August 11, 2016

Tom Kozlik
U.S. STATE AND LOCAL GOVERNMENT SECTORS 215-585-1083

State Enhancement Programs for School

thomas.kozlik@pnc.com

Districts
Many U.S. state governments have programs that enhance school district debt. The broad goal of
the enhancements is to increase the marketability of school district bond issues, with the
rationale being that increased marketability and resulting demand should lower borrowing costs
for schools and thereby reduce the fiscal burden on state and local taxpayers. Policies that lower
bond costs and save taxpayer money allow states to use scarce financial resources in other
productive ways. These enhancements are also a way state governments can help school districts
make long-term investments in K-12 education. For investors, the enhancements offer another
layer of security, in addition to the underlying credit quality of the school district, to be considered
when deciding among the numerous municipal bond investment options. Program by program,
these state enhancements possess distinct legal and structural features but are often considered
part of four general categories:
 State guarantee;
 State appropriation pledge;
 Intercept mechanism; and
For investors, the
 Permanent fund. enhancements offer
another layer of security,
in addition to the
State Guarantee underlying credit quality
of the school district, to
A limited number of states pledge a state guarantee in the event that a school district fails to fund
be considered when
a debt service payment. States offering this protection agree to tap its general fund or other deciding among the
available funds to cure a debt service funding deficiency. All but one state guarantee enhancement numerous municipal
program possess ratings that are the same as their respective state ratings. The exception is in bond investment options.
Idaho, which has an enhanced rating one notch above the state’s rating. Idaho’s School Bond
Credit Enhancement Program combines the security of the state guarantee and the Idaho Public
School Endowment Fund backing. In most cases, we would expect the rating of state guarantee
enhancements to move up or down in concert with the state rating.

State Appropriation Pledge

A few states offer school district bond enhancements based on a standing or annual appropriation
pledge. The key difference between the state guarantee and the appropriation pledge is typically
that the state is not required to use any available state resources to solve a debt service
deficiency. Most appropriation programs are referred to as standing appropriation programs and
are not subject to annual appropriation risk. One appropriation program subject to annual
appropriation risk is the South Carolina School District Credit Enhancement Program.
Appropriation programs typically receive a rating that is the same as the state rating or a notch
lower. This enhanced rating will likely move in tandem with the state rating.

Intercept Mechanism
The intercept is the most common type of state enhancement for school district bonds. Intercept
programs or mechanisms can seize, capture, or otherwise “intercept” state aid payments that are
scheduled to be paid to school districts to satisfy a debt service funding shortfall. Intercept
programs are set-up to divert funds on a Pre-default or Post-default basis. The result is that
funds are intercepted before a debt service default in a program with a Pre-default mechanism. A

Please see analyst certifications and important disclosures on page 4.

warning, typically from the state or a third party, about a potential debt service deficiency is
required to trigger a Pre-default intercept. With a Post-default, it is the default itself that triggers
an intercept of funds. The funds a state can draw upon or intercept differs program by program. Unlimited advance – the
Funds available for intercept are generally described as the following: strongest type of
intercept because it
 Unlimited advance - the strongest type of intercept because it pledges any legally
pledges any legally
available source the state has at its disposal, or according to the specific program; available source the state
 Directly funded - from aid allocated to the school district; has at its disposal, or
 Limited advance - available funds at a level that is higher than aid allocated to according to the specific
program.
schools but lower than any available state source; and
 Current year - can access aid allocated to school district in a single year.
Rating agency school district intercept enhancement ratings have ranged from zero to three
notches below the state rating, but there are exceptions, such as the recent treatment of
Pennsylvania School District Intercept programs.1 Intercept ratings sometimes but not always
move in tandem with state rating actions.

Pennsylvania’s Act 85 of 2016 Strengthens PA’s Intercept in Case of

Budget Impasse
A new state law2 allows the Pennsylvania Department of Education, in the event of a state budget It is important to
impasse, to request available Pennsylvania General Fund money if needed to make a debt understand that while the
service payment. This became a concern last year when Pennsylvania school districts were not new provisions
receiving state aid payments during an extended budget delay, reducing the value of the state’s strengthen the PA
enhancement program for school districts because there was no state aid to intercept. intercept mechanism,
they do not guarantee
It is important to understand that while the new provisions strengthen the PA intercept debt service payments
mechanism, they do not guarantee debt service payments will be paid. There are limitations: will be paid.
Payments cannot exceed 50% of school districts’ nonfederal subsidy in the prior year. Funds are
limited to available cash balances at the time of the intercept. And the Commonwealth is
restricted from issuing tax anticipation notes or entering into a loan agreement with the PA
Treasury for liquidity to provide intercept payments.
It is currently unclear how, or if at all, Moody’s Investors Service and Standard & Poor’s will adjust
their opinions and enhanced ratings for the Pennsylvania School District Intercept Programs as a
result of this new law.

Permanent Fund
Only a small number of State Permanent Fund enhancements exist. State Permanent Funds are
State Permanent Funds
formed under a state’s constitution but do not possess a direct connection and are not linked to
are formed under a
the state’s rating. Therefore, a Permanent Fund rating would not necessarily move up or down in state’s constitution but
conjunction with a state rating. Permanent Fund credit quality stems from factors such as a fund’s do not possess a direct
investment holdings, asset and liability metrics, and investing guidelines and policies. connection and are not
linked to the state’s
Sources rating.
State Aid Intercept Programs and Financings: Pre and Post Default (Rating Methodology) by Moody’s (July 8,
2013).
State Credit Enhancement Programs: Current List and Program Descriptions, S&P (August 4, 2016).

Notes
1
Please see Rating Agencies Overhaul Treatment of PA School District Enhanced Ratings, June 8, 2016.
2
Please see Pennsylvania Act 85 of 2016, HB1605 pages 103-106.
.
 3

Summary of School District State Enhancement Programs

4