WASHINGTON -- Lease bonds have been weathering the recession better in Indiana and Kentucky than in most states, with few downgrades and no defaults reported, according to a new John Nuveen & Co. report.

The report says this is largely because both states prevent issuers from legally opting out of their lease payments.

At a time when lease securities have come under greater scrutiny because of their greater risks, and because the recession has made it more difficult for issuers to budget lease payments, Indiana and Kentucky are proving that leasing can still be a success story, the report says.

Entitled How Indiana Lease Bonds Work, by Nuveen analyst John Illyes, the report attempts to explain why leasing is working so well in the two states where it has the longest track record.

Neither state has seen a lease default after nearly 50 years of lease issuance primarily because "neither state permits a lessee to legally nonappropriate" payment for a lease security, the report says.

That puts Indiana and Kentucky leases a step above their counterparts in most othe states, where state and local issuers include "nonappropriation clauses" in their lease contracts to prevent the securities from being construed as debt and coming under state debt restrictions.

Besides prohibiting any casual termination of a lease, both states "stringently monitor local lessees to ensure that all rental payments are budgeted and appropriated in a timely fashion," a backstop for investors that has helped to prevent even slight delays in lease payments, the report says.

In Kentucky, the auditor of the commonwealth will not approve a local government's budget unless it provides for lease payments, while the Indiana State Board of Tax Commissioners -- which by statute must approve all local lease issues -- can increase local property taxes, if necessary, to cover rental payments.

Besides having direct authority over local budgets, both states have shown in test court cases that they were willing and able to withhold state monetary aid from localities that refused to make lease payments. Indiana even has the power to "intercept" state school aid payments to ensure leases are paid.

"Since the Indiana and Kentucky constitutions severely limit general obligation borrwoing, both states recognize leasing as an indispensable tool for accessing the capital markets. This 'enlightened self-interest' ... is why neither state has ever allowed a lease to default," the report notes.

The extraordinary security provisions the two states provide to their lease offerings also explain why the offerings receive unusually high ratings and maintain those ratings despite hard times.

In most states, leases are graded a notch below general obligation bonds. In Indiana, "the ratings agencies are comfortable enough with leases that in an overwhelming majority of cases an issuer's lease-backed debt is rated exactly the same as its GOs," the report says. Indiana School Building Corp. lease bonds, because of the state aid intercept mechanism, receive an "automatic A" from the agencies, it says.

The high ratings earned by the two states' lease securities make them more recession-proof than other states' lease issues. The report points out, for example, how a major downgrade of New York state in 1990 caused the state's lease ratings to fall to only a notch above "junk" status.

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