OVERVIEW AND SCOPE

This article describes our criteria for rating debt issues involving unconditional third-party credit support fully covering principal and interest and/or liquidity support. These forms of support are typically used in variable-rate debt obligations (VRDOs) in primary markets and tender option bonds (TOBs) in secondary markets. These structures feature an underlying obligor (often a U.S. municipal entity), and the obligations are supported by a letter of credit and/or liquidity facility or standby bond purchase agreement (SBPA). See Appendix 4 for an overview of these structures and Appendix 6 for a glossary of technical terms. The criteria also apply to pooled TOBs when the trust contains fewer than 10 different underlying securities (i.e., assets).

Structures analyzed under these criteria achieve credit substitution through linkage to the credit rating on a credit support provider. This is because support can only be terminated or revoked in circumstances that are either remote or captured in our rating on the underlying obligation or credit support provider.

The criteria do not apply to the analysis of liquidity support in asset-backed commercial paper (ABCP) conduits, or to debt obligations supported by guarantees, insurance, or derivatives (which are rated using different criteria). However, if such transactions include the remarketing of tendered bonds, we complement the primary criteria applicable to those transactions with an analysis of remarketing risks under these criteria.

Context And Analytical Fundamentals

When analyzing obligations supported by letters of credit or bank liquidity facilities, our credit rating opinion has two analytical components: our forward-looking opinion of the creditworthiness of (i) the underlying obligation and (ii) the provider of the letter of credit (LOC) or relevant liquidity facility. Accordingly, in these criteria, "rating" or "rated obligation" (for example, the rating on the underlying obligor or support provider--that is, the LOC or SBPA provider) is a reference to S&P Global Ratings' credit rating opinion on the entity or obligation. Where relevant, a correlated short-term rating may sometimes be inferred from a long-term rating by S&P Global Ratings, as described in the chart below.

METHODOLOGY

Section 1: Linkage To Rating On The Supporting Party

When credit support is provided unconditionally, the ratings assigned to the supported issue are directly linked to the issuer credit rating (ICR) on the support provider. This applies to both long-term and short-term ratings.

In addition, the short-term rating assigned to liquidity-supported debt addresses the likelihood of payment of mandatory tenders or tenders at the option of investors by the third-party support provider. In some circumstances, the tender could terminate without the investor first being paid--we analyze these situations as described in "Section 4: Support Termination Risk."

If two or more third parties jointly support an issue, we apply our methodology and assumptions for rating jointly supported financial obligations. Examples include LOC-supported debt additionally secured by a back-up LOC or a rated obligor's obligation to pay debt service. If we believe the repayment sources are highly correlated, we may link the assigned debt rating to the highest-rated repayment source. If two or more partially supporting parties combine to wholly support debt repayment (several support), the debt rating is typically the same as the rating on the lower-rated supporting party.

In general, rating substitution through linkage will remain throughout the life of the issue, except:

• If the short-term rating on liquidity-supported debt reflects a demand feature (typically in a dual rating), the rating is withdrawn when transaction circumstances lead to the termination of the put option (i.e., upon loss of a put option).
• If the supported debt is legally and structurally defeased, these criteria no longer apply and the ratings may be withdrawn. Subject to available information, we may be able to rate the defeased debt by applying criteria for assigning ratings to bonds in the U.S. based on escrowed collateral.
• In multi-modal structures, when the mode on all the debt is converted to a mode that no longer requires a credit or liquidity facility (for instance, when the debt is converted to a long-term or fixed-rate mode), the rating is withdrawn since the obligation it is based on ceases to exist.

Section 2: Legal And Regulatory Risk

The main legal and regulatory risks we factor in our analysis are enforceability, recapture, and bankruptcy remoteness of special purpose-entities (see table 1).

Table 1: Legal And Regulatory Risks

Section 3: Sufficiency Of Support

This section focuses on typical risks and common mitigating factors relating to the sufficiency of the available support to make full and timely payments on the rated obligations. Our assessment of sufficiency of available support is based on the terms of supporting agreements and potentially on further considerations identified in Section 2.

Table 2: Sufficiency Of Support--Risks And Mitigants

Document-related timing risk

Sufficiency of coverage of principal and interest (see text below for details)

Coverage for bonds with put options and commercial paper structures (see text below for details)

Additional debt

Further considerations for sufficiency of coverage analysis

Sufficiency of coverage of principal and interest.  We review whether the support facility covers the maximum principal scheduled together with accrued interest (and any premium), including the payment of purchase price associated with a failed remarketing, as applicable. The relevant factors are:

• The maximum interest rate that could be payable on the debt while the facility is in effect;
• The maximum number of days between interest payment dates (including interest accruals periods, if different and including any reinstatement periods) for all interest rate modes to which the assigned rating applies;
• The terms for interest accruals on the debt (including analysis of the first interest accrual period, if longer); and
• The remedies the trustee can use to repay the debt should the LOC provider exercise any option to not reinstate interest coverage.

Stressing for interest coverage is usually based on the following assumptions (see Appendix 2 for a worked example):

• Interest accrues at the maximum rate covered by the enhancer, as defined in the debt instrument;
• The interest reinstatement period is stressed to assume that the LOC provider and trustee will exhaust the maximum time allowed (for example, the LOC provider will, on the last day and/or specified time that it has the right to do so, provide notice that it is not reinstating interest coverage, and the trustee will, on the last day that it is obligated to do so, complete the steps described in the transaction's documents for repaying investors);
• If a trustee must rely on direction from a notice, in the absence of notice timing, the notice arrives at the end of a given business day and the trustee will take action on the following business day; and
• When either party may choose between two or more options, the party will choose the option that could result in the greatest amount of interest accruing on the debt.

If the "most favored nation" (MFN) clause applies, loss of coverage can result from changes to preconditions to funding or conditions to purchase/fund (see table 3 for details).

Coverage for bonds with put options.  If there are insufficient proceeds due to a failed remarketing or rollover, investors are expected to be repaid with funds provided from a draw on the enhancement.

To avoid a shortfall, the party required to draw on the enhancement (typically the trustee) may be required to draw by the deadline established under the enhancement in an amount equal to principal and interest due to investors minus any proceeds on deposit with the remarketing or dealer agent (or the trustee itself). Drawing based on actual proceeds on hand, rather than solely on the notice of the amount of debt remarketed or rolled over, also mitigates the risk of a settlement failure (a purchaser failing to deliver payment after a security is traded).

Likewise, the analysis looks to identify whether the proceeds of a successful remarketing or rollover would be delivered to the trustee prior to the draw deadline or prior to the time required to pay investors. In the latter case, the remarketing agent or dealer may be required to transfer those proceeds to the trustee prior to the time they are due to investors. Alternatively, the trustee may make a draw on the enhancement assuming such proceeds did not materialize.

In addition, we consider whether the remarketing agent or dealer is required to transfer any proceeds in its possession prior to its resignation or removal for deposit with the trustee. If not, the remarketing or dealer agent may be restricted from resigning or being removed prior to such transfer of proceeds.

When bank-purchased tendered debt is subsequently remarketed, the available bank's commitment is replenished by the amount of debt that has been resold together with accrued interest. When a purchase of tendered debt is made with a facility draw, the facility provider or the trustee, as custodian, usually holds the purchased debt (often referred to as "bank bonds"). We assess whether transaction provisions sufficiently mitigate the risk that the custodian (if it is not the facility provider or the trustee) could release an amount of debt to new investors that exceeds the amount of reinstated third-party coverage. For example, the custodian may be restricted from releasing any purchased debt (or bank bonds) until the facility provider has confirmed the reinstated facility amount to the custodian in writing.

Section 4: Support Termination Risk

Support facility agreements include provisions that can lead to a termination of the support provided. We assess whether transaction documents mitigate the risk that support may terminate before investors have been repaid. Remedies that ensure investors are repaid before the support terminates include mandatory tender, mandatory redemption, or acceleration. This analysis includes suspensions or automatic termination events (ATEs) in liquidity facility agreements (e.g., SBPAs).

Specific examples of termination risks and common mitigants included in transaction documents are in table 3.

Table 3: Support Termination--Risks And Mitigants

Automatic termination of liquidity support

The typical risks associated with ATEs in liquidity facility agreements (e.g., SBPAs) and common mitigants are in table 4. As appropriate, we review and assess alternative mitigants in transaction structures. Termination risk is mitigated if the circumstances that trigger an ATE are captured in our rating on the credit support provider and/or the underlying obligor, or are otherwise outside the scope of the rating (such as a change in law).

Table 4: Automatic Termination Events (ATEs) In Liquidity Facility Agreements--Risks And Mitigants

Further considerations for the analysis of ATEs in the liquidity support agreement

ATEs in liquidity facility agreements that are based on the following events are consistent with the linkage approach under these criteria because they are either remote or factored into our rating on the supported obligation (see Appendix 3 for ATEs applicable to insured liquidity facilities):

• Failure by the obligor to pay the bonds being rated, including bank bonds, or repudiation of the rated bonds. An ATE referencing a failure to pay or repudiation of accelerated bank bonds is not consistent with the linkage approach. (Bonds purchased by a liquidity provider following a failed remarketing can, at the bank's demand, be accelerated and require immediate payment. Similarly, if a bond insured transaction contains acceleration provisions, bond insurer consent should be required prior to declaration of acceleration.)
• Failure by the obligor to pay, or repudiation by the obligor of any debt that is senior to or on parity with the rated debt.
• The obligor begins proceedings related to bankruptcy, insolvency, reorganization, or relief from debtors; the obligor admits, in writing, that it's unable to pay its debts as per the applicable bankruptcy code; or an involuntary bankruptcy event occurs.
• The issuer, the obligor, a government authority, or a court challenges the validity or enforceability of the bond or liquidity documents, or challenges the validity or enforceability of the pledged security associated with the rated bonds. Challenges by the issuer, obligor, government authority, or court with respect to any material provisions of the bond or liquidity documents relate to the payment of principal and interest on the bonds or bank bonds. Following a finding or ruling, only government authorities and/or courts with appropriate jurisdiction over the bond transaction being rated are considered. Challenges by the issuer or obligor are those made officially through a formal written action.
• A governmental authority or a court with jurisdiction over the issuer or obligor imposes restrictions that negatively affect parity debt (for example, debt moratoriums or debt restructuring, debt adjustments, or comparable extraordinary restrictions). Such imposition is as a result of a finding or ruling by the government authority or court.
• Dissolution of the issuer as a result of reorganization without any assumption of all debt obligations, excluding the support provider's preference to the party assuming the debt.
• A final non-appealable court judgment that is not satisfied by the obligor within 60 days of the final judgment.
• Bond payments are declared taxable in the U.S. by the IRS.

Events that we do not consider remote include a failure to pay fees under the liquidity facility or other transaction documents; a failure to pay any subordinated debt or debt not rated by S&P Global Ratings; and a covenant default that leads to termination without notice of the bank's obligation to purchase tendered bonds.

Ratings-based ATEs

Liquidity facility agreements may contain an automatic termination provision if we lower the rating on the obligor to below investment grade (i.e., below 'BBB-') for credit-related reasons, or suspend or withdraw it. There are three possible outcomes in that event:

• If transaction circumstances lead to the termination of the put option (i.e., a loss of put option), the short-term rating that reflects the demand feature of the rated debt is withdrawn.
• If the put option continues to exist and under the agreement the obligor may, but is not obligated to, fund the put, we also withdraw the rating to reflect optionality in the agreement.
• If, under the agreement, the obligor remains committed to honor the put, the short-term rating, if any, is maintained under our sector-specific (i.e., U.S. public finance) criteria.

The initial rating in table 4 (the rating threshold of 'A') refers to the point in time when the transaction is first rated by S&P Global Ratings, not any subsequent rating upon a remarketing (for example, following enhancement changes).

Table 5 illustrates how short-term ratings on a SBPA-supported obligation could transition assuming the initial rating on the obligor is 'AA-/A-1+', reflecting ratings-based automatic termination.

Table 5

Section 5: Application Of Other Criteria

Specific considerations are relevant when applying other criteria that cover third-party supported transactions (see the Related Criteria section).

To assess the sufficiency of support provided in a transaction structure (see Section 3 for details), we analyze its flow of funds under our global cash flow criteria.

Under our operational risk criteria, we assess whether the structure explicitly describes and assigns responsibilities that, if not performed as agreed upon by key transaction parties (KTPs), may adversely affect the rating. Table 6 provides examples of how we apply our operational risk criteria to specific aspects of structures analyzed under these criteria.

The counterparty risk framework does not apply where counterparty risk (for example, bank account risk) is managed by the underlying corporate or government obligor, typically in LOC- or SBPA-backed structures. The counterparty framework is relevant when structures use a special purpose entity. See table 6 for examples of how we apply our counterparty risk framework and temporary investment criteria to specific aspects of structures analyzed under these criteria.

Table 6: Other Criteria Assessments

Operational Risk Assessments

Counterparty Risk Assessments

Temporary Investment Assessments

APPENDICES

Appendix 1: Analyzing Recapture Risk

Recapture risk may be present in standby LOC-supported transactions and in other transaction types if debt payments to investors are made by the underlying obligor. This appendix covers the various forms of claw-back risk that can take place in the U.S., where these transactions are typically domiciled, and some of the common mitigating factors.

Recapture risk in LOC-supported debt: direct-pay, prioritized direct-pay, and standby LOC

In a direct-pay structure, funds drawn under the LOC are the first source for repaying investors; therefore, recapture risk is not present. Obligor funds reimburse the support provider, and investors are paid only with support provider funds.

In a prioritized direct-pay structure, investors are vulnerable to recapture risk because LOC funds are a secondary payment source available to be drawn upon if the primary source of funds is insufficient. The obligor is the primary source of funds. In transactions governed by U.S. law, mitigation of the risk consists of making funds "preference-remote." The process often involves a trustee, which represents investors, by:

• Paying the debt with obligor funds that were aged for the appropriate preference period before being used to pay investors, and
• Verifying that the obligor did not become bankrupt during the aging period.

In a standby LOC structure, investors are vulnerable to recapture risk because they are usually paid first with obligor funds that may not be aged or otherwise preference-remote. LOC funds are used to cover payment shortfalls. Therefore, in transactions governed by U.S. law, we review whether the support agreement and other transaction documents include provisions requiring the support provider to pay, on the investors' behalf, monies that are clawed back from investors as preferential transfers in a bankruptcy of the obligor.

Such provisions shift preference risk from investors to the third-party support provider. Considerations for the analysis include assessing the maximum aggregate amount of debt service payments that may be subject to recapture (to verify that the standby LOC will be sufficient to cover them) and evaluating the risk of recapture after the debt has been fully repaid. Regarding the risk of recapture, we assess whether transaction provisions require the trustee to continue performing its duties and make third-party support available to be drawn until no risk of recapture remains, including following the final obligor payment. (An example of this is after the longest applicable preference period has expired and the trustee has received a certificate of "no bankruptcy filing" from an authorized officer of the obligor.)

Funding sources that mitigate obligor-related recapture risk in transactions governed by U.S. law include:

• Initial debt sale proceeds;
• LOC draws, provided the LOC is subject to International Standby Practices (ISP) 98, or the LOC provider explicitly has agreed to make payments with its own funds;
• Remarketing proceeds, if restricted (see below);
• Funds held by the trustee for at least 90 days or the applicable preference period (for example, one year if payments are to "insiders," as defined by the U.S. Bankruptcy Code [the Code]), during which time there has not been a bankruptcy filing by or against the obligor;
• Insurance proceeds paid directly to the trustee, as a beneficiary (on the investors' behalf) of an insurance policy;
• Proceeds from a refunding debt issue; and
• Other monies, if accompanied by a preference opinion by a nationally recognized bankruptcy counsel concluding that payments to investors from a specified source of funds would not be preferential transfers.

Transactions that include put options

Recapture risk may exist when rated debt includes an investor put option where a tender occurs and the LOC or SBPA provider funds any deficiencies caused by failed remarketings, depending on the sources of funding used to settle the put.

Usually in such structures, a remarketing agent will remarket any securities that have been tendered, and the proceeds of the remarketing are the first source for funding principal and interest payments (purchase price) to tendering investors. In most cases, the transaction documents restrict the remarketing agent (i.e., the broker-dealer) from remarketing debt to the obligor and the issuer, if they are different, as well as to any of the obligor's guarantors and affiliates. In transactions governed by U.S. law, the remarketing agent may, however, purchase tendered debt for its own account and at its sole discretion, paying investors with its own funds, and then resell the debt to any potential buyer (including the obligor). Tendering investors would not be exposed to preference risk as a result of the obligor's bankruptcy because they would have received a payment from the remarketing agent's own funds, as opposed to a payment from the obligor.

New third-party support of previously issued debt

Recapture risk can occur in the U.S. when an obligor grants the LOC provider new or additional collateral for:

• Agreeing to support previously issued but unsecured or undersecured debt (such as by providing additional credit support following the deterioration of preexisting credit support), or
• Replacing a departing provider (i.e., LOC substitution).

We may request legal opinions to address the issue.

Optional redemptions

In some transactions, payments due to investors (i.e., principal, interest, and/or premium) upon an optional redemption are not supported by a support provider and this creates potential recapture risk, depending on the payment source.

We review whether transaction documents include certain restrictions for the trustee in order to mitigate the risk, such as:

• The trustee cannot send a notice of optional redemption to investors unless it has enough preference-remote funds on deposit;
• The trustee cannot send an optional redemption notice unless it explicitly conditions the redemption on the trustee to have sufficient preference-remote funds to make the redemption payment by the scheduled redemption date; or
• The trustee cannot send an optional redemption notice unless it states that a redemption will occur only if sufficient preference-remote funds are available.

Standby LOCs

The extent to which recapture risk is sufficiently covered depends on the following factors:

• Loan agreement (or equivalent document) payment due dates;
• Loan agreement grace periods for curing obligor payment defaults;
• The longest applicable recapture period;
• The sum of all payments (including principal) that could be due under the loan agreement during the longest applicable recapture period; and
• If the LOC does not reinstate following a draw, the provisions for and timing of remedies to repay investors (for example, acceleration following an event of default due to trustee notice of obligor bankruptcy or loan agreement payment default) relative to the date of obligor bankruptcy.

(Appendix 2 includes a worked example.)

Insured liquidity facilities

Bond insurance policies typically cover scheduled payments of principal and interest. If a payment event is not a scheduled event (such as an optional redemption), we review whether such optional redemption is made with preference-remote monies.

Additional considerations

When the obligor is a U.S. entity, we generally view recapture risk as limited to preference risk under section 547 of the Code. Under section 547 of the Code, a bankrupt debtor's estate may void and recapture certain property transfers, potentially including payments made by the debtor to service and/or repay existing debt. Transferred funds may be subject to recapture if they were made during the 90 days (one year, if payments are to "insiders," as defined in the Code) that preceded the debtor's bankruptcy filing. Therefore, there may be a risk that debt service payments to investors in U.S. law-governed LOC-supported debt may be recaptured as a voidable preference if an obligor becomes bankrupt. This does not apply when the obligor is a municipality under Chapter 9 of the Code because debt payments by municipalities are not subject to recapture according to Code section 926.

We analyze recapture risk of LOC-supported debt secured by additional rated sources of credit support (for example, an LOC with bond insurance or a fronting LOC with a confirming LOC). The insurance policy, confirming LOC, or rated obligor typically does not cover a direct-pay LOC bank's insolvency risk. However, we usually assume that preference risk arising from LOC bank insolvency is remote in the U.S.

We generally view the risk that funds drawn under an LOC issued by a U.S. bank will be recaptured as remote, regardless of whether the bank is FDIC insured. Depending on the particular facts and circumstances we may request a legal opinion that addresses this issue in any given case.

Non-U.S. banks (including their U.S. branches) may be subject to the general bankruptcy provisions or bank-specific statutes that apply in their particular jurisdictions. Non-U.S. statutes often require, as a precondition of a preferential claw-back, knowledge by the payee of the payor's insolvency at the time the payment was made. Multiple jurisdictions and governing laws might be involved when a non-U.S. bank is the LOC provider, and we may request legal opinions addressing recapture risk in these situations.

Appendix 2: Worked Example--Assessing Sufficiency Of Coverage

The example below illustrates the potential size of the maximum exposure in a worst-case scenario, when assessing sufficiency of coverage under Section 3.

The main components of a worst-case scenario (LOC structure) are:

• Maximum bond coupon days;
• Potential notice timing under the LOC; and
• Potential remedy time to full bondholder payout should the LOC not reinstate.

Sample

Interest rate mode:  

• Weekly rate mode, monthly interest.
• Payable on the first Thursday of a month ("a name day"), the interest payment date (IPD).

LOC reinstatement provisions:  

• Interest reinstates on the ninth day unless notice is received by the eighth day that an event of default has occurred under the reimbursement agreement directing either a mandatory tender or acceleration.
• The LOC will terminate 15 days after receipt of notice.

Bond document provisions:  

• Acceleration: Declare acceleration immediately upon receipt of notice from the bank. Interest ceases to accrue upon declaration of acceleration.
• Mandatory tender: Tender no later than the third business day following receipt of notice.

Worst-case scenario:  

• IPD to IPD: 35 days.
• Depending on the transaction details, interest coverage stresses will utilize different months of the year. Typically, we use the months of January and September in a monthly pay structure because these months have U.S. holidays that stress the maximum days between IPDs.
• Notice period: 12 days. Bank notice is eight days. However, unless the transaction documents state that notice must be received by the close of business on the eighth day, we will assume that the bank may send notice at any time on the eight day, which may be after the close of business. While performance will only occur on a business day during regular business hours, we assume calendar days, unless business days are stated. Under this stress scenario, we will consider the trustee's receipt of bank notice to be the next subsequent business day and will then proceed to take action as outlined in the transaction documents. In our example, this is the Tuesday after Martin Luther King Jr. Day in January, hence 12 days.
• "Remedy" time (the time before the bonds are paid out): Acceleration is declared on the date of notice receipt (with interest ceasing to accrue on the date of declaration)--48 days. Mandatory tender is the third business day after receipt of notice--51 or 50 days, depending on whether the transaction documents state when interest accrues vis a vis the mandatory tender date. (Our stress scenarios assume that interest accruals will include the mandatory tender date unless stated in the transaction documents that interest accrues up to, but not including, the mandatory tender date.)

Assessment:   Depending on interest accrual vis a vis the mandatory tender date, the worst case scenario is 51 days of interest coverage when interest accrual includes the mandatory tender date and 50 days of interest coverage when interest accrual does not include the mandatory tender date.

Appendix 3: ATEs For Insured Liquidity Facilities

We generally consider that ATEs based on events 1-5 and 7 below are remote or already factored into the underlying ratings. Event 6 reflects a ratings-based ATE (see Section 4 for details).

• 1. Insurer declaration of insolvency or admission of inability to pay its debts in writing, or a proceeding is commenced against the insurer by an oversight body or court of appropriate jurisdiction, the effect of which would be to declare the insurer insolvent.
• 2. Insurer default under any bond insurance policy, fee surety bond associated with the issue, or surety bond issued by the insurer that insures or supports the payment of principal and interest on municipal obligations.
• 3. Issuer substitution of the insurer or cancellation of the insurance policy without the liquidity bank's written consent, provided that a corresponding covenant requiring the issuer to receive the liquidity bank's consent is included in the documents.
• 4. Insurer contests or repudiates the validity or enforceability of the bond insurance policy, or fee surety bond associated with the issue, or any provision thereof affecting the obligation of the insurer to pay thereunder.
• 5. A finding or ruling by a court or governmental authority with jurisdiction to rule on the validity of the bond insurance policy that the policy, or any provision thereof affecting the obligation of the insurer to pay thereunder, is not valid and binding on the insurer.
• 6. We suspend, withdraw, or lower the rating on the bonds to below investment grade (below 'BBB-') for credit-related reasons.
• 7. The IRS declares that the bonds being rated are taxable.

Another possible payment event is acceleration of the debt. However, unless specifically noted in the bond insurance policy, insurers will not fund accelerated debt unless the acceleration happens with their prior written consent. Therefore, the trust agreement typically states that acceleration can only occur with the bond insurer's prior written consent.

Special mandatory redemption of bonds held by the liquidity facility provider is another payment event. However, unless specifically covered under the bond insurance policy, insurers will not fund this special mandatory redemption. Therefore, the endorsement or rider to the bond insurance policy evidences coverage of this redemption.

Appendix 4: Product-Specific Examples And Application

Variable-rate demand obligations (VRDOs)

A VRDO is usually multimodal (meaning it allows for different interest rate modes taking place simultaneously), with an embedded demand feature (such as a put option). VRDOs can be supported by an LOC or a liquidity facility--usually a standby bond purchase agreement--and are sometimes supported by two or more rated parties.

In LOC-supported VRDOs, both the short- and long-term ratings are directly linked to the ICR on the LOC provider (see charts 1 and 2 for examples). Similarly, the short-term rating assigned to LOC-supported commercial paper (CP) reflects the ICR on the LOC provider (CP is often a mode in VRDOs).

In order to enhance liquidity to fund tenders, a liquidity facility can be provided to fund the purchase price of bonds that cannot be successfully remarketed, typically via an SBPA. In these structures (see chart 3), the short-term rating is the lower of the rating on the support provider and the short-term equivalent of the long-term rating on the issuer (or the short-term rating, if available). The long-term rating is not supported by the SBPA and simply reflects the rating on the issuer.

TOBs

Tender option bonds (TOBs) are secondary-market derivative products. Tax-exempt USPF debt obligations are typically deposited into a specially instituted trust and the tax exemption is passed on to the trust. If the underlying assets are taxable, then the certificates issued by the trust will also be subject to taxes. Underlying USPF deposits can come in various forms, typically as deposited municipal bonds, notes, leases, custodial receipts, or anticipation notes. The trust, in turn, issues synthetic floating-rate receipts with a tender option (referred to as "synthetic floaters") and inverse floating-rate receipts (referred to as "residuals").

TOB floater and residual certificates may only be marketed to qualified purchasers (see chart 4 for a typical TOB structure).

A floater's tender option is supported by liquidity, and, in some structures, the underlying collateral is also supported via an LOC or a municipal bond insurance policy (see chart 5). Joint support applies when the underlying rated collateral is enhanced by an LOC via a custodial receipt arrangement (see chart 6). The enhanced custodial receipt is then the underlying collateral for the TOB trust.

We assign a dual rating to synthetic floaters. The liquidity facility provides coverage for unremarketed tendered floater receipts. We assign only a long-term rating to the residual certificates.

The long-term rating on floaters is based on the rating of the underlying obligation. The rating addresses the likelihood of the holder receiving par plus any accrued interest based on regularly scheduled principal and interest payments from the underlying obligation. S&P Global Ratings' municipal ratings do not address the likelihood that the interest payable on the receipts or the underlying bonds may be deemed or declared includable in the gross income of synthetic floater holders by the relevant authorities at any time. The ratings also do not address the likelihood of the obligor making any payments in excess of principal and interest, such as premium on redemption payments from the underlying obligations or gain share payments. When a TOB trust contains multiple assets (subject to limits on multiple assets discussed below in Appendix 5), the long-term rating on the trust certificates reflects the lowest-rated asset in the trust.

The long-term rating on residuals addresses timely payment of interest and full payment of principal. Residuals do not have a tender option and the long-term rating on the residual reflects the rating on the underlying obligation. Interest paid to residual holders generally equals the "leftover" or "residual" interest collected on the underlying obligation, following the payment of interest to the floater holders, minus any fees and any reimbursements owed to the liquidity provider. When proportionality between the floater and residual holder is adopted, such interest is measurable, but may be low or zero given a maximum floater interest rate.

Appendix 5: Specific Rating Considerations For TOBs

Trusts that contain 10 or more differently issued underlying securities are not in scope of these criteria. The linkage approach under these criteria is intended for trusts with five or fewer assets. We analyze trusts that have more than five (but fewer than 10) assets on a case-by-case basis. We consider the degree of correlation between assets. If the assets are likely to be highly correlated, we may still apply the linkage approach. If not, we may consider alternative approaches that would likely produce a rating outcome that is lower than that of the lowest-rated asset in the trust.

Further considerations for linkage analysis in a defeasance situation (Section 1)

When the underlying asset in a TOB structure is fully or partially defeased and the certificates are not fully called, the outstanding rating on all floaters and residuals may be withdrawn. If the defeased underlying bonds are assigned an escrow rating, the rating of such defeased underlying bonds is reflected in our rating on the TOBs.

Further considerations for sufficiency of support (Section 3)

Sufficiency of coverage of principal and interest.  Some liquidity structures involve an additional party who may voluntarily step in ahead of the liquidity provider to purchase certificates. Regardless of the form, we assess whether the rated liquidity provider agrees to fund the full par and accrued interest on a given purchase date. Given this additional support is optional, it does not factor into the ratings assigned.

If the underlying obligations are variable-rate interest obligations, we assess whether the interest paid to the trust is subject to a cap and account for both fixed and variable underlying obligations when analyzing the TOB interest rate setting mechanism for sufficiency of coverage by liquidity.

We assess potential document-related timing risk that may be caused by mismatches between the date the interest rate is set for the trust versus the variable-rate underlying obligation.

Additional TOB debt.  Issuance of additional debt can result in the trust being undercollateralized or can alter the composition of the existing underlying collateral. Common mitigants (meaning preconditions to additional issuances known as "bond criteria") that we assess are:

• The additional collateral is from the same bond issue as the existing collateral, and
• The additional collateral relies on the same principal credit source, has the same interest payment date, and the same rating as the existing collateral.

Further considerations for support termination risk (Section 4)

Tender option termination events (TOTEs).  Upon specified TOTEs occurring in a TOB structure, the floater holders' tender option terminates, the liquidity facility terminates, and the trust winds down after a grace period of generally five days. In such an event, the certificate holders either receive liquidation proceeds from the sale of the underlying collateral and/or a payment in kind, and we assess that the orderly distribution of assets results in a full payment of par and accrued interest on the certificates.

Our analysis assumes that payment of principal and interest is made pari passu with the senior-most class in the capital structure. In the event of a payment in kind, we review that the documents provide for a pro rata distribution of the share of the underlying obligation.

The liquidation of underlying obligations to pay noteholders can introduce market value risk to holders. Common mitigants include a liquidation test in which the trustee ensures that the bids solicited by the remarketing agent are sufficient to cover full par plus accrued interest and trust fees. Otherwise, the trustee is directed to distribute the securities in kind. In addition to sufficient proceeds, we assess whether there are any timing or other operational issues related to the solicitation of bids or liquidation of the securities that could affect a timely payment to holders in the event of termination (see Sections 3 and 5 for further details).

Certain TOTEs lead to termination without notice. The following events speak to credit deterioration of the underlying deposit and a change of tax status, and include ratings-based events subject to the rating threshold (see Section 4 for further details):

• The issuer of the underlying obligation fails to pay principal or interest when due, and such failure is not cured during any designated cure period (if applicable). If the bond rating is based on credit enhancement, payment default is limited to the credit enhancement provider. If the rating on the underlying obligation is based on the application of joint-support criteria, then the TOTE cannot occur until both entities providing support fail to pay principal and interest when due and such failure is not cured during any designated cure period (if applicable).
• The issuer of the underlying obligation files for bankruptcy. If the obligation's rating is based on credit enhancement, bankruptcy is limited only to that of the credit enhancement provider. If the rating on the underlying obligation rating is based on the application of joint-support criteria, bankruptcy applies to both entities providing support.
• The underlying obligation is deemed taxable.
• S&P Global Ratings' rating on the underlying obligation falls below investment grade (below 'BBB-'). We rate the receipts only if they are derived from underlying obligations that, at the time of the initial trust rating, have an enhanced, unenhanced, or jointly supported rating of at least 'A' or higher (the rating threshold); this is the same as our approach for ATEs in SBPA. We consider the initial trust rating to refer to the point in time when the trust is first rated by S&P Global Ratings and not any subsequent ratings that may be related to future remarketings.

Mandatory tender events (MTEs).  Mandatory tender events are typically triggered by noncredit-related events and can cause the trust to unwind. They can pose a risk to the appropriate collateralization of residual receipts. This is because the direction by the liquidity provider to sell the underlying assets prior to drawing on the liquidity facility can result in sale proceeds that are only sufficient to cover the floater certificates.

When rating residuals, we assess whether all the underlying assets are sold and whether a related amount of underlying assets, up to the residual allocated share, is set aside to cover the residuals (known as "reserve bonds").

Residual holders can elect to subordinate payments due upon certain MTEs where funds are directed to the liquidity provider in reimbursement. In these circumstances, we consider subordination to be consistent with our repack criteria (see below) because the residual holders are still entitled to their funds at an appropriate nonsubordinated place in the payment waterfall and actively choose to direct the money.

Further considerations for application of other criteria (Section 5)

Repack criteria.  These criteria apply to TOBs in conjunction with our global methodology for rating repackaged securities. Certain types of USPF deposits may not be consistent with our repack criteria (for example, perpetual assets that expose investors to market value risks and equity deposits).

Custodial analysis covered in our repack criteria is relevant when rating TOBs. A custodial arrangement with credit enhancement in the form of an LOC may be used where the underlying bond does not meet the trust's documented rating threshold (joint support may apply in this case). Given the nature of TOBs' custodial structures, their analysis focuses on whether the underlying assets deposited are:

• Irrevocable;
• Free and clear of any lien or encumbrance;
• Not commingled with other assets; and
• Maintained in a separate designated account for each issue, where cash flows are available to make timely and sufficient payments to holders regardless of fees payable.

Consistent with repack criteria, we assess that the authorized denomination of the underlying obligation is the same as the authorized denomination of the synthetic floaters--such that the underlying obligations do not accrue sufficient interest because of the occurrence of a prepayment.

Further considerations--nonstandard underlying assets

Nonstandard forms of USPF deposits are evaluated on a case-by-case basis. They can pose additional risks, such as denomination mismatches, reset dates on variable underlying obligations, the analysis of bankruptcy remoteness, or potential tax and legal implications of debt versus equity.

Potential mitigants include a final maturity date upon which the underlying securities pay the stated amount of principal assigned at issuance, and structures providing credit enhancement to pay full and timely principal and interest regardless of underlying security payment deferrals.

An example of these structures includes zero-coupon capital-appreciation bonds. We assess whether the issuance schedule contains a forward-looking schedule of placed receipts in advance of the payment date, and if the trust documents contain take-out provisions prior to the payment date if receipts cannot be successfully placed. We consider whether liquidity automatically increases in coverage by the amount of additional floater receipts issued and interest due on any payment date in accordance with the accretion schedule.

Appendix 6: Glossary

The following glossary comprises terms frequently used in S&P Global Ratings' analyses of VRDOs and TOBs. The definitions are limited to how these terms apply when reviewing these types of securities.

REVISIONS AND UPDATES

This article was originally published on March 20, 2023.

Changes introduced after original publication:

• On Oct. 11, 2024, we republished this criteria article to make nonmaterial changes. We removed the sections related to the original publication of the article, updated the Related Publications section and the contact information, and clarified certain language in table 4.
• On Oct. 17, 2024, we republished this criteria article to make nonmaterial changes. We removed additional material related to the original publication of the article.

RELATED PUBLICATIONS

Related Criteria

• For U.S. public finance sector-specific criteria, see: Table of Contents: S&P Global Ratings U.S. Public Finance Criteria
• Methodology And Assumptions For Market Value Securities, July 26, 2024
• Environmental, Social, And Governance Principles In Credit Ratings, Oct. 10, 2021
• Global Framework For Payment Structure And Cash Flow Analysis Of Structured Finance Securities, Dec. 22, 2020
• U.S. Structured Finance Asset Isolation And Special-Purpose Entity Criteria, May 15, 2019
• Counterparty Risk Framework: Methodology And Assumptions, March 8, 2019
• Methodology For Linking Long-Term And Short-Term Ratings, April 7, 2017
• Asset Isolation And Special-Purpose Entity Methodology, March 29, 2017
• Guarantee Criteria, Oct. 21, 2016
• Methodology And Assumptions For Rating Jointly Supported Financial Obligations, May 23, 2016
• Global Framework For Assessing Operational Risk In Structured Finance Transactions, Oct. 9, 2014
• Global Derivative Agreement Criteria, June 24, 2013
• Global Methodology For Rating Repackaged Securities, Oct. 16, 2012
• Global Investment Criteria For Temporary Investments In Transaction Accounts, May 31, 2012
• Principles Of Credit Ratings, Feb. 16, 2011
• Structured Finance Criteria Introduced for Cayman Islands Special-Purpose Entities , July 18, 2002

Other related publications

• S&P Global Ratings Definitions, updated from time to time