Moody's Investors Service's Aug. 15 downgrade of the Philadelphia School District to Ba3 was another indication of the district's growing financial problems.
Yet analysts voice little concern about the fate of the district's $3.1 billion in bonds.
Their confidence is a reflection of the state government's support of the debt, rather than of the troubled school district.
The district has general obligation and school lease revenue bonds, both covered by versions of the Pennsylvania State Aid Intercept Program.
In the GO program, in the case of a default the state would divert state aid for the district to the bond trustee. For the lease revenue bonds, a portion of the aid is consistently diverted to the bond trustee.
Five bond analysts consulted for this story and all three ratings agencies are fairly comfortable that the intercept program provides safety to bondholders. While Moody's has an underlying rating of Ba3 on the GO debt its enhanced rating is A1. Fitch Ratings has an underlying rating of BB on the debt and an enhanced rating of AA-minus. Standard & Poor's does not have an underlying rating but it has an enhanced rating of A-plus.
Evercore director of municipal research Howard Cure and Janney Montgomery Scott managing director Alan Schankel both said that Moody's downgrade may have a small negative impact on the bonds prices in the secondary and, if the district issues more debt in the future, the primary market.
A state aid mechanism held up well under stress in Detroit's bankruptcy, Cure said.
"This security has seemed to hold up in the case of Detroit's Distributable State Aid debt which doesn't appear to be forced to take a haircut compared to other Detroit debt issuances," he said.
Secondary market trading data from Markit for Philadelphia School District 's 2020 maturity shows that the district's bonds have consistently traded in yield above Municipal Market Data's single-A general obligation level during the last three years, despite the district's higher enhanced ratings. In October 2013 Fitch had the district's enhanced rating at AA. S&P's enhanced rating has been steady at A-plus since at least 2000.
Investors may have been taking the district's low underlying rating into account and demanding additional yield on the district's bonds.
Since about May 2013 the spread of the district's bonds' yield to the single-A yield has contracted.
Despite Fitch's downgrade of the underlying rating in October 2012 and Moody's downgrades of this rating in July 2013 and on Aug. 15, 2014 market participants were increasingly trading the bonds closer to the A level. This would be consistent with the tightening spreads for riskier bonds that has prevailed in the last 15 months.
Markit projects that on Aug. 21, 2012 a district bond maturing in eight years would have traded 116 basis points above Municipal Market Data's single A GO eight-year maturity bond. On Aug. 21, 2013 the spread for a seven-year district bond had shrunk to 33 basis points above MMD's single A GO seven-year maturity. On Aug. 21, 2014, the spread for a six-year district bond was the similar 36 basis points to MMD's single A GO six-year maturity.
The Moody's downgrade is just one of several financial developments for the district in the last few months and there are other developments expected in the next few weeks.
In mid-summer Superintendent William Hite Jr. said the district might have to delay opening in September because of a lack of money. In response, Pennsylvania Gov. Tom Corbett released $265 million in state aid early to the district. Of this $265 million, $120 million will come from an extension of a 1% city sales tax.
On Aug. 15 Hite unveiled cuts to purchasing, building cleaning, school security, student transportation, and school nurse staffing. Together they are supposed to save the district $32 million this year.
The district is lobbying for a $2-per-pack cigarette tax in Philadelphia that it believes would yield $80 million each year. When the Pennsylvania legislature was in session, the House passed the tax but the Senate rejected it because it was in a bill that had other measures that senators did not like, said Loop Capital vice president Rachel Barkley.
Cure, Schankel, and Miller Tabak Asset Management chief executive officer Mike Pietronico said they believe lawmakers will pass the cigarette tax in the next few weeks. The legislature will reconvene on Sept. 15.
The ratings agencies have said that the district's financial troubles are due to several factors. Chief among them are the shift of many of its students to charter schools.
The portion of the city's public school students attending charter schools has increased from 11% in 2004 to 32% in 2013, according to Moody's analyst Dan Seymour.
State law dictates that the district has to transfer money to charter schools for each student who chooses to attend them.
The district also suffers from the fact that it does not have taxing authority but depends on the state and city governments for funding.
The city has an above-average poverty and unemployment rates, Seymour said.
The district has "closed 32 facilities, negotiated two concessionary contracts and cut more than 5,000 positions over the last four years," said district chief financial officer Matthew Stanski. "Additional savings on the operational side will be extremely difficult."
Seymour agreed.
The district finished fiscal year 2014 with an operating fund deficit equal to 1.2% of revenues, Seymour said.
Moody's said the district's debt burden as a percent of the city's property valuation, at 3.2%, is moderate. Fitch characterized the burden as high.
The district said it was taking several steps to improve its financial situation and overall operations.
In a first phase of building sales, the district has sold seven buildings for $27 million, Stanski said. It has bids for another 14 buildings for a second phase of sales.
The district is seeking benefits concessions from teachers on par with those accepted by other employee groups, Stanski said.
The district is opening three new schools this year and has expanded or opened three others over the past two years to compete with local charter schools, Stanski said.
The district has neither authorized any new charters nor expanded seats in the existing charter schools for two years.
"A fair funding formula for all Pennsylvania school districts would increase long-term sustainable funding to the school district," Stanski said.
State Rep. Cherelle Parker, D-Philadelphia, said that the solution for the district was the creation of a needs-based equitable school funding formula statewide. The state's current enrollment-based funding is not needs-based, she said. A school system's costs do not go down at the same proportion as enrollment goes down because it still has to pay for electricity and heating and other costs for schools.
The district needs predictable funding from the state, Parker said.
The state legislature has formed a Basic Education Funding Commission to come up with recommendations on state education funding, Parker said. In June 2015 the commission is to issue a report with recommendations.
Gov. Corbett is looking to several measures to provide a long-term solution for the district, his spokesman Jay Pagni said. Corbett supports the district's surplus property sales.
He is open to signing the cigarette tax. He has signed an indefinite extension of a 1% city sales tax, which generally provides the district $120 million a year. Pagni also said Corbett wants the teacher's union to do more to cut costs.
Finally, Corbett is open to hearing the funding commission's recommendations next summer.
Cure said that since the district's funding is tied to enrollment, it needs to increase its education quality to make its schools more attractive to students and parents.
Schankel said the district needs a permanent source of funding and the cigarette tax would be a positive step for the district. The city government should also consider increasing its real estate taxes to support the district.
While Philadelphia in general is doing well right now, in the long-term it will not thrive without a good school system, Schankel said. The city needs to continue to take measures to address the district's problems, he said.
