S&P Global Ratings downgraded $212 million of Detroit Public Schools bonds to junk.

CHICAGO -- Detroit Public Schools' $212 million of state aid-backed bonds received a downgrade to junk from S&P Global Ratings, citing uncertainty over the bonds' security after a restructuring of the school district.

The district was formally divided into two separate entities on July 1 under a $600 million state package approved this year by state lawmakers to stave off a potential bankruptcy filing as the district grappled with insolvency.

The new Detroit Public Schools Community District operates schools and will receive the future state aid payments that had secured the 2011 and 2012 bonds. The bonds also carry a limited tax general obligation backing.

S&P lowered the 2011 first lien bonds three notches to BB from BBB and the 2012 second lien bonds to BB-minus from BBB-minus. The action Thursday followed another recent three-notch downgrade when S&P raised concerns over the status of the bonds after the new district formally opened its doors July 1.

"The downgrade is based on the lack of a formal plan regarding bondholder repayment terms following the recent restructuring of the district, and the resultant elimination of a pledged revenue stream at the end of the state's fiscal year," said analyst Jane Ridley. The state's fiscal year begins Oct. 1.

"Although the intent is to take out the existing debt at full value, in our view, as October approaches and ushers in the new fiscal year, it creates greater uncertainty as to whether bondholders will receive full and timely payment on their bonds."

The ratings remain on CreditWatch with negative implications reflecting the possibility that further hits could result if a redemption, refunding, or defeasance is not undertaken in a timely manner.

"If the actions taken through this process provide bondholders with anything less than the full promise of the original bonds, it is likely to be considered a distressed exchange and therefore a default under our criteria," Ridley said.

State Treasury officials have said the restructuring of the state aid bonds won't impair principal. The office did not have an immediate comment Thursday on the downgrade. Officials with the new DPS also were not immediately available to comment.

The bond had garnered A-level ratings despite the district's underlying junk-level ratings because of the state backing. The former district, referred to as Old Co, remains intact solely to continue to collect its tax millage and repay its tax-backed bonds and is now the obligor of the state aid bonds.

State aid can only flow to school districts with students, so the only remaining fundable pledge backing the bonds when the state starts its next fiscal year will be the district's limited tax GO pledge, which is not rated by S&P.

"Because state aid will no longer support the bonds effective Oct. 1, 2016, in our view the situation must be resolved by then or bondholders will lose a critical revenue stream, which would result in a significant reduction in value," S&P said.

The three-member Local Emergency Financial Assistance Loan Board last month approved a $150 million loan to help fund the new district's start-up costs and authorized $235 million in school financing stability bonding to restructure the state-aid backed bonds.

Municipal Market Analytics last month said it too remains concerned over a lack of detail on the restructuring's short-and long-term impact on the district's bonds.

"The complexity surrounding the split and the allocation of debt and revenue sources raises concerns regarding the execution of the plan to repay bondholders in the short-term," MMA wrote.

MMA called it "disconcerting" that bondholders must rely on the state but "the odds lean in favor of the state doing what is necessary to avert the default/distressed exchange possibility just weeks after congratulating itself on providing the fix for DPS."

MMA has greater long-term worries because the current operating levy would be leveraged to repay the restructured bonds.

"This debt would likely be considered unsecured in the context of a Chapter 9 bankruptcy," MMA said.

The district's existing, non-state aid backed-debt is repaid with an 18 mill levy that expires in 2022 and would require voters to reauthorize it. The state has estimated that repaying the district's existing debts would take 10 years.

DPS's debt also includes $1.5 billion of unlimited-tax general obligation bonds.

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