WASHINGTON - The strength of a municipality's economy is a crucial factor in evaluating sales tax-backed bonds, Standard & Poor's Corp. reported yesterday.

"The health of the local economy is central to the rating process," the rating agency said in the Dec. 21 edition of CreditWeek Municipal. The bonds are attractive to investors because they are backed by taxes on a broad range of goods and are supported by the overall economy.

In evaluating sales tax debt, which has become increasingly popular as municipalities struggle with legal and political constraints on raising other types of taxes, Standard & Poor's focuses first on the breadth of the sales tax base.

"As a general rule, levies on the widest range of items earn higher ratings than those on limited categories of goods and services," Standard & Poor's said.

Other considerations include cyclical factors, like tourism, that may create fluctuations in sales tax receipts. In addition, Standard & Poor's examines sales tax growth rates. Extremely high growth may overstate sales tax collections because a large portion may be attributable to nonrecurring construction-related sales, the agency said.

Standard & Poor's also evaluates the diversity of a municipality's retail base. For example, a small town might get most of its sales tax revenues from one shopping center that faces the possibility of future out-of-town competition.

"A poorly performing or concentrated economy may limit the upside potential of a bond rating despite the level of debt service coverage." Standard & Poor's said.

The agency also warned that rapid growth in retail sales, which generally would be considered a welcome development, may not be a positive rating factor.

"Fast growth in retail sales, a positive factor from a coverage standpoint, also may indicate a growing economy with substantial future capital needs," Standard & Poor's said. "Rapid growth alone may or may not be positive for ratings, depending on the size of the bonding needs that accompany it."

Another important element in rating sales tax bonds is evaluating the adequacy of legal covenants, such as the so-called additional bonds test. In this test, the issuer agrees not to sell additional debt unless certain conditions are met. For example, a municipality could pledge that revenues will cover annual debt service by a set percentage.

The percentages set by the tests generally range from 1.2 times coverage of debt service to 3 times, with most in the 1.25-to-1.5 times range, according to Standard & Poor's. In general, the higher the percentage, the higher the bond rating, the agency said.

Standard & Poor's said, that to be meaningful, the coverage provided by the additional bonds test should provide "a sufficient cushion against revenue declines ... plus an extra safety margin." The agency added that there is no set rating for particular coverage levels, "since each city's economy is unique."

Another consideration in rating sales tax bonds, Standard & Poor's said, is whether or not there is a fully funded debt service reserve.

"For most municipalities, inflexibility in raising tax rates during a revenue downturn makes having a fully funded debt service reserve very important," the agency said. "A debt service reserve will cushion against the possibility that pledged revenues temporarily will not cover debt service in a recession."

The rating agency noted that under most sales tax bond deals, revenues not needed to pay off the debt revert to the municipality.

"Cities that subsequently use surplus sales tax revenues for ongoing general fund expenditures have less incentive for additional sales tax bonding," Standard & Poor's said. "A resulting history of high coverage and the expectation of sales tax issuance below maximum allowable levels can improve the rating of sales tax bonds the city does issue."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.