Joseph Krist

Publisher

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ISSUE OF THE WEEK

California Health Facilities Financing Authority

$684,475,000*

SUTTER HEALTH

TAXABLE BONDS

$606 million

Tax-exempt Revenue Bonds

In the current environment, this large Northern California hospital system has determined that a taxable refunding generates sufficient savings to justify refinancing tax exempt debt with proceeds of the issue. The bonds come to market with Aa3/AA- ratings. Concurrently, the system will issue tax exempt debt to fund its significant ongoing capital program. The system plans some 44.9 billion of capital spending over the next five years.

Bonds are secured by a gross revenue pledge pursuant to Sutter’s 1985 Master Trust Indenture (MTI), with payments made by Sutter’s Obligated Group (approximately 99% of the System’s total revenues). All members of the Obligated Group are jointly and severally liable with respect to the payment of each obligation secured under the MTI. Financial covenants include a debt to capitalization requirement of less than 60%, a debt service coverage requirement of over 1.1 times, and a days cash on hand requirement of over 70 days.

Sutter  operates 29 acute care facilities, operates a small health plan, manages a large number of out-patient facilities, and manages five medical foundations that contract with medical groups organized as professional corporations that account for the services of 2395 physicians. In fiscal 2017, Sutter Health produced over $12 billion in revenues, and generated over 193,000 admissions.

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FEDERAL TAX CUT WILL BOOST STATE CORPORATE TAX REVENUES

The Council On State Taxation has released a study “The Impact of Federal Tax Reform on State Corporate Income Taxes”, produced through the efforts of Ernst and Young (EY) researchers. The report estimates the impact of federal tax changes on the tax position of companies.  The EY study assesses the impact that the corporate tax provisions of the TCJA will have on respective states’ corporate income taxes. Its overall conclusion is that conformity with federal tax reform will result in an estimated state corporate tax base increase averaging 12% for the first ten years, with a range generally between 7% and 14% in individual states.

According to the report, the average expansion in the state corporate tax base is estimated to be 8% from 2018 through 2022, which increases to 13.5% for the period 2022 through 2027. This increase in the later years is primarily attributable to research and experimentation (R&E) expense amortization beginning in 2022 and the change in the calculation of the interest limitation in the same year. The federal tax base expansions due to interest limitation, research and expenditure amortization, limitation of like kind exchange for personal property, and fringe benefit limitations total approximately 10%. Since virtually all of the states conform to these provisions, these changes represent a large portion of the overall expansion of the tax base in most states.

According to the report, the largest expansions in federal corporate tax base arise in the manufacturing and capital-intensive service industry sectors due primarily to the transition tax. The finance and holding company sector will be impacted mostly by the impact of the federal NOL limitations and the transition tax and GILTI. The labor intensive service sector will see the smallest overall increase in federal taxable income. While it is somewhat affected by the transition tax and the business expense interest limitation, it benefits almost equally from the expansion of bonus depreciation and the move to a territorial tax system.

What all of this implies is that, in the first year, there is a positive potential impact on state revenues as the result of the federal tax cuts. Whether this is a long run positive depends on how corporate taxpayers react. We would expect pressure to be brought to bear on state legislatures to make adjustments to their own tax codes to account for this non-legislative increase. We do have concern that as this process sorts itself out, the resulting increases in tax liability may mute the positive intended economic impact of the federal tax cut. In particular, the larger share of base expansion assigned to the manufacturing sector may help to dampen the employment impact intended by the proponents of the tax cut.

We note that states traditionally associated with manufacturing – Pennsylvania, New Jersey, New York, Iowa, Massachusetts, and Missouri – to name a few have the highest percentage rates of expansion in their corporate tax base as the result of the federal changes.

CENSUS DATA SHOWS IMPACT OF HOUSING COSTS

The US Census Bureau released data this past week revealing population trends for the country’s major metropolitan areas. Among these was Wayne County, MI which is substantially comprised of the City of Detroit. The good news for the city is that the area is now ranked ninth on the list of declining county populations rather than third as was the case in 2017. This is attributable to, among other things the availability of housing in the City of Detroit.

One criticism of the City’s efforts on renewal in the post-bankruptcy era is that it has mainly attracted higher income workers back into the city. The availability of lower cost affordable housing has not been as readily addressed. Now the State of Michigan and the City have announced a program to begin to address that demand. To the surprise of no one, it will rely in a substantial way on tax exempt financing.

Detroit is creating a $250 million affordable housing fund that would preserve 10,000 affordable housing units with expiring low-income housing tax credits and create 2,000 new ones on vacant land or in existing vacant buildings by 2023. The fund would be made up of $50 million in grant funding; $150 million in low-interest borrowing; and another $50 million in city and federal funds over the next five years.

The fund will comprise monies from bank financing, low-income housing tax credits, tax-exempt bonds, brownfield financing and historic tax credits. The first project funding commitments are expected early next year. Last year, the City Council approved an ordinance requires housing developers who receive a certain threshold of public subsidies or discounted city-owned land in Detroit to set aside at least 20% of their units for lower-income residents.

NEW JERSEY TOBACCO REFUNDING HIGHLIGHTS RECENT USE TRENDS

The State of New Jersey is undertaking a current refunding of outstanding tobacco securitization debt. The issue gives us a chance to look at historic sales data and the accompanying projections of future sales trends supplied in the prospectus. This issue will have a final maturity of 2046 and features the well established “turbo” maturity schedule which, if met, would retire approximately one-third of the bonds within 14 years.

The O.S. shows that sales of cigarettes have been declining in this century at an average of 3% per year. The rate of decline has not been consistent with large drops attributable to the Great Recession and price and taxation events. Sales actually increased twice (albeit less than 2%) on a year over year basis. The forecast of cigarette consumption which is included in the prospectus calls for annual declines in sales of 2.9% annually through 2046 (the final maturity of the bonds).

The State receives 3.8669963% of the annual $9 billion of payments made by the original and subsequent participating manufacturers under the terms of the Master Settlement Agreement. These payments are pledged to the repayment of the bonds on a subordinate basis. There is also a $52 million reserve to be maintained for the bonds.

These bonds will refund debt with a final maturity of 2041 so there is some extension of the maturity risk associated with this issue.

We have always taken the view that tobacco bonds are primarily a professional institutional investor trading vehicle. We believe that the historic price volatility that the sector has experienced due to the typically extended duration of the bonds is more than the typical individual investor should be expected to handle on their own. Nothing about the structure or security position of this issue causes us to change our view.

CONNECTICUT TO SELL BONDS IN THE FACE OF A DEFICIT

The State of Connecticut will try to sell some $600 million of general obligation bonds in the wake of the latest current deficit assessment. The State Comptroller last week announced that the State faces a General Fund deficit from operations of $192.7 million, an improvement of $2.1 million from the level reported in February. Projected revenues remain unchanged from the level reported last month. The figure does not include the impact of a deposit which is required to be made to the State’s Budget Reserve Fund if General Fund revenues exceed $3.5 billion as is expected to be the case.

Without action to mitigate the projected deficit, the balance in the BRF, after transfers to extinguish the FY 2018 deficit, is projected to be $685.1 million, equivalent to 3.6% of FY 2019 General Fund appropriations. If the projected deficit is resolved without utilizing resources from the BRF, the balance in the reserve will reach $877.8 million, or 4.7% of FY 2019 General Fund appropriations. Expenditures are estimated to be $16.2 million above the budget plan. The expenditure and revenue estimates assume that the budgeted level of rate increases and supplemental payments to hospitals will be made, and that the budgeted amount of the hospital user fee and federal revenue will be collected.

Statutory provisions require the state to process certain hospital rate and supplemental payments in advance of full federal approval. The state’s submissions are currently under federal review, but it is unclear whether and when federal approvals will be obtained. If approvals are delayed beyond the end of the fiscal year, there could be a budgetary impact of approximately $150 million.

All of this is reflected in S&P’s latest statement on Connecticut’s credit. It affirmed its ‘A+’ rating on the state’s approximately $18.5 billion of GO debt outstanding, its ‘A’ rating on state appropriation-secured debt, and its ‘BBB+’ rating on state moral obligation debt. The outlook on all long-term debt is negative. S&P cited revenue weakness because of slow economic growth and recent population decline and reduced revenue-raising flexibility after the state instituted substantial tax increases in the past two biennium budgets. Less expenditure flexibility following implementation of new constitutional spending caps; reductions in state aid to localities; implementation of a recent labor agreement that reduced costs, but also created fixed pay schedules and prohibits layoffs over the next four years; and rising fixed-debt service, pension, and OPEB expenditures all contribute to the outlook.

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