Fitch Ratings has downgraded the underlying rating to BBB-minus from BBB on approximately $2.8 billion of outstanding bonds of the Philadelphia School District and the Pennsylvania School Building Authority.

The downgrade comes ahead of the authority’s $300 million school lease revenue bond sale for the district, scheduled for next week.

The new bonds were assigned an enhanced AA rating, based on the Pennsylvania School Credit Enhancement Direct-Pay Intercept Program, which requires the withholding of state appropriations and their direct payment to bondholders.

“The downgrade of the underlying rating largely reflects the continued deterioration of the district’s already tenuous financial position,” analysts said in a report.

“Its ongoing challenge to maintain even a minimal level of reserves is evidenced by its use of the deficit bonds now offered.”

Proceeds from the bond sale are expected to be used to close a projected $225 million accumulated deficit in the district’s operating fund in fiscal 2013, and an additional $75 million deficit projected in fiscal 2014.

The Philadelphia School District is the nation’s eighth largest school district, and the largest in Pennsylvania. Plans to achieve structural balance rely heavily on the district’s ability to achieve dramatic savings, particularly from upcoming negotiations with the teacher’s union, the report said.

“Fitch believes the level of cooperation needed from the union and the community to fully realize these plans will likely not be forthcoming, resulting in continued negative operations and increased accumulated deficits,” analysts said.

The report also cited the district’s limited ability to raise revenue, elevated debt levels, and a notable amount of management turnover. The district recently hired a new superintendent and is currently seeking a new chief financial officer. If the district fails to implement the level of cost-cutting measures needed to avoid further deterioration of its financial position, Fitch will likely downgrade the bonds.

Any further cut to its rating will take the bonds to junk status.

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