Trio of firsts for Santa Cruz Metro’s inaugural deal

The Santa Cruz Metropolitan Transit District will achieve several firsts when it prices $51.7 million of taxable sales tax revenue bonds Wednesday to pay down pension liabilities.

The deal is likely the first long-term debt issued by the transit agency, it will be the first transit agency to issue debt to pay down a pension liability and it’s the first time an all-Latino finance team was hired by an issuer.

As the first bond sale of its kind for the transit agency, it should “create a nice buzz with investors, because it’s an opportunity for investors to diversify their portfolios,” said Raul Amezcua, a senior managing director for Ramirez & Co., lead manager on the deal. “There aren’t that many inaugural credits in a year, so it really creates a buzz.”

It’s not only a brand new credit in that category, it’s also the first time the transit agency has issued long-term debt in at least 30 years, and maybe ever. The most recent filing on the Municipal Securities Rulemaking Board’s EMMA website is for short-term notes that matured in 1993.

The bus service, established in 1978, provides commuter service throughout Santa Cruz County, which is 32 miles southwest of San Jose, on its regular lines as well as operating a paratransit service on smaller buses. It also has a contract with the University of California-Santa Cruz and Cabrillo College, a two-year college, where students pre-pay for bus service so they can board by merely showing their student identification cards.

At its height in 2019, the transit agency provided bus service to five million riders, fell to its low point of 900,000 of ridership in fiscal 2021 while university students learned remotely from their homes. It expects to surpass three million riders in fiscal 2022 with the area colleges back to in-person learning, Chuck Farmer, the transit agency’s chief financial officer, said.

It was a “feat,” to secure its AA rating from S&P Global Ratings for the previously unrated issuer, because of how most other transit agencies focused on bus service are funded, Amezcua said.

“Most transit agencies operate at a deficit, because the farebox doesn’t cover the cost of operating the bus lines, and then they rely on federal and state grants to cover costs,” Amezcua said. “So, when those issuers come to market, they are in the A bond rating category.”

Unlike many transit providers, Santa Cruz Metro benefits from Measure G, a 0.5% cent sales tax approved by voters in 1978 that will repay the bonds, which Amezcua said helped the transit agency to achieve its rating. It also has the ongoing contract with the two colleges, Amezcua said.

Since the debt is being issued as a sales tax revenue bond, as opposed to a traditional pension obligation bond, Santa Cruz Metro did not need to validate the proposed bonds in the courts, said Juan Galvan, a shareholder at Jones Hall, and bond counsel on the deal.

The validation process can take up to three or four months, NHA Advisors’ Michael Meyer told The Bond Buyer. And it, can take even longer if an anti-tax group decides to challenge the validation in court.

A trend developed beginning in 2019 of California local governments issuing more POBs as local governments faced pressure for higher payments when the California Public Employees’ Retirement System reduced its amortization schedule to 20 years from 30 years.

California is still the state that has issued the most POBs since 2018, but its share of issuance decreased in 2021 as other states increased their new issuance, according to a Sept. 15 report from S&P Global Ratings.

Nine months into 2021, issuance of nearly 80 deals totaling $10.5 billion in par amount had far surpassed the $6 billion sold the prior year, according to a Sept. 27, Municipal Market Analytics report.

“We decided to issue debt, because our pension plan was one-third unfunded, and as part of that process CalPERS, which manages our pension charges 6.8% on that outstanding balance,” Farmer said. “With the current low interest rates, if we issue at 3% that would save the taxpayers money.”

Santa Cruz had an unfunded accrued liability of $68 million as of June 30, 2020, according to its offering documents. But given it has achieved a 21.3% return on investments, an estimated $16.2 million credit from CalPERS is expected to reduce the UAL to $51.4 million, said Julio Morales, a UTI managing director and the financial advisor on the deal.

Even if the debt sold as high as a 3.5% interest rate, the transit agency would save money, Farmer said. “We looked at other ways to fund it, other than bonds, but it was overwhelmingly the best solution.”

With clients who are contemplating issuing bonds to pay down pension liability, Morales said they look at the availability of reserves, discretionary payments or doing a leveraged refunding as other options. But given Santa Cruz Metro doesn’t have other outstanding debt, a refunding wasn’t an option, he said.

“We also drafted a pension funding policy that helps them going forward,” Morales said. “It’s a new standard that we draft for all clients.”

Some of the savings achieved by paying down the pension liability, which will affect the transit provider’s budget positively, will be used to fund zero emission buses, Farmer said.

Given that federal and state grants are competitive, and require somewhere in the neighborhood of a 10% match from the transit agency, the money could help accelerate the grants they can apply for, Farmer said.

It can also help the transit agency get ahead of the curve on moving its fleet to electric to meet future state mandates.

California mandates that all buses purchased after 2028 be either electric or hydrogen cell-powered, and that by 2045 the entire fleet fit that model.

“With the potential savings, we could set ourselves up for a great future,” said Farmer, who anticipates that many transit agencies will be competing for electric buses as the deadline to switch over to greener buses draws near.

Santa Cruz Metro currently has four electric buses in its fleet, Farmer said. Currently, electric buses cost $1 million, compared to $750,000 for diesel, Farmer said, though he expects the cost for electric or hydrogen-cell buses to decline as they become more prolific.

While Farmer and the finance team are sold on the benefits of issuing bonds to eliminate the current UAL, the financing mechanism has its detractors.

In its report on POBs, MMA analysts ticked off what it sees as the problems, challenges and risk with the financial mechanism, including that they can create generational equity problems, because most POBs involve a long-term speculation where the risks are entirely carried by future taxpayers and government service recipients, who have no say in the transaction’s creation. Additionally, annual investment returns consistently above the bond’s interest rate are difficult to safely assume, and history suggests they are vulnerable in bankruptcy, as most Chapter 9 adjustment plans gave their largest cuts to POB payments.

The Government Finance Officers Association issued an advisory in 2015 that local governments should not issue POBs; and it hasn’t modified its stance since then.

Morales called the kind of pension debt that has been issued since 2017, POB 2.0 — though what Santa Cruz is issuing are technically sales-tax revenue bonds, not traditional POBs.

“The vast majority of all pension bonds issued for the last four or five years have been double-A rated or higher,” Amezcua said. “I think the post-2008 investors analyze the credits more closely.”

“The pension bonds issued prior to the more recent POBs were issued just in anticipation of savings; these we are doing as part of a plan,” Amezcua said. “They create a pension reserve. It’s a more well thought-out pension plan.”

The rating agencies also view the newer, more conservative fixed-rate structures, with 10-year call options and no derivatives, more favorably, Morales said.

“Issuers can now articulate how they are using the savings,” Morales said. “All of these things are seen as positive. They are actively managing their liability, and the approach is far more in depth.”

Other transit agencies, across the country are exploring the possibility of issuing debt to deal with their pension liability, said Michael Mejia, a senior vice president with Ramirez said. In its report, S&P noted that issuance of pension-related bonds spread in 2021 from mainly local governments to special districts and other issuers

As for the make-up of the finance team, Amezcua said, “it’s the first time in my 31 years of working on municipal debt in California that all the members of the working group are Hispanic, except for the issuer.”

“Everyone was selected based on qualifications through a request for proposal,” Morales said. “We didn’t realize the entire finance team was Latino until we gathered to discuss the deal.”

No race or ethnic group constitutes a major of California’s population, but 39% are Latino, 35% are white, 15% are Asian American or Pacific Islander, 5% are Black, and less than 1% are Native American, according to a Public Policy Institute of California break down of 2020 U.S. Census information.