CHICAGO — Moody’s Investors Service Tuesday downgraded its long-term rating on DePauw University to A3 from A2, warning that the small Indiana liberal arts school suffers from deeply imbalanced operations.

The downgrade affects $120 million of outstanding bonds. Of that, 63% is in a variable-rate mode, nearly all of which is hedged with interest-rate swaps and supported by letters of credit.

Located in the town of Greencastle, DePauw is considered a top-tier private liberal arts college. Its fiscal position is boosted by strong liquidity and a strong gift-giving program.

But the school has suffered from years of deep operating deficits and weak cash flow, Moody’s said.

It operates in a highly competitive market and its tuition, at $14,289, is significantly lower than the median tuition of $21,281 for other A-rated small private colleges rated by Moody’s.

The competitive market has forced DePauw to offer aggressive tuition discounts, and one of university management’s key plans for stabilizing finances is raising net tuition per student.

The school’s poor operating performance has led to a decline in debt-service coverage levels.

The decline in coverage triggered a covenant in a letter of credit with Harris Bank, but DePauw has since substituted the LOC with new support from PNC Bank NA, which does not feature a debt-service coverage requirement.

It was the LOC substitution that prompted the Moody’s review, analyst Diane Viacava said.

The LOCs do feature covenants and events of default that, if breached, could trigger a mandatory tender of the bonds and an accelerated repayment to the debt that would strain the school’s liquidity, Moody’s warned.

Meanwhile, the downgrade to A2 could trigger a collateral posting on one of the university’s three swaps, though as of Tuesday the school had not yet posted any collateral.

In addition to its strong liquidity, DePauw is strengthened by a relatively new management team that is working to improve the school’s fiscal position, Viacava said.

Brian Casey took over as president in July 2008, coming aboard after stints at Harvard University and Brown University. He has since built a new management team that is working to cut expenses and boost operations, said Viacava.

“You have a very committed board and management team,” she said. “They’ve been working very hard in trying to bring the school slowly back to balance, and it takes time to do that.”

Management is working to increase net tuition per student and promote the school’s reputation, and has already cut about $4 million from its operations.

DePauw typically issues its debt through the Indiana Finance Authority. Moody’s is the only credit agency that rates the school’s debt.

Its bonds are not secured by any mortgage or lien on property.

Recent trading activity showed little volatility in DePauw’s bonds. A 2009 term bond with 5.75% coupon and a 2039 maturity was trading in early March at 5.37%, down slightly from 5.45% last December.

Bonds with a 4.75% coupon maturing in 2022 saw a yield of 4.75% in the most recent trading, which was last July.

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