Matthew Coit | July 23, 2018
Across the country, municipalities have been facing increasing pressures to cut costs, stemming from rising levels of emigration—which hinders tax revenues and causes reductions in state funding levels. For an area like New England, cities and towns are under the gun to become more efficient with available funds and to cut costs if they want people to keep living here.
With bonding as such a prevalent source of public funds, the credit rating of a municipality is critical, as it can have a large impact on both the availability of that funding and amount of interest that will need to be paid. Maintaining and increasing a credit rating, however, can be a challenge.
Many of the factors used to determine a municipality’s credit rating can be out of the direct influence of the municipality – this generally includes items of an environmental, legislative, economic, or regulatory nature. However, there are still several areas that are in direct control of a municipality and can contribute to a strong rating, namely in financial management and in debt management:
Financial Management
The most important controllable factors for any municipality in maintaining or improving its bond rating are in financial management. Rating agencies look to see that an organizational system is in place that shows planning for meeting obligations before they become due, and such a system is generally evidenced by the following:
- Contingent Liability Policy – A policy outlining the levels of the contingency, its purpose, and intended use are recommended.
- The “10-Year” Plan – Going well beyond the next fiscal year and planning further into the municipality’s future for capital investment, related funding, and similar large expenditures.
- Economic Development Plan – Including a long-term strategy to not only retain top talent and business in the area but to grow and continue to develop economically.
- Age of Capital Assets – Particularly in towns and cities that have seen decreases in revenues, capital assets will often be used well past their useful lives. This indicates a risk to rating agencies that there is no plan in place for the replacement of these assets and a greater risk that unforeseen costs may arise should these assets cease to operate.
- Cybersecurity Issue Management – This is an area gaining traction given the increased prevalence of cybersecurity threats. Rating agencies will consider how past cybersecurity issues have been addressed, especially as a poorly handled situation is often viewed as an indicator of weaker risk management.
- Fund Balance Policy – This outlines appropriate fund balance levels for the municipality and the situational use of them.
All of these areas show that municipal management has a vision beyond the current budget year. Rating agencies look favorably on cities and towns that have this vision as well as adherence to the policies; it is indicative of an entity that is well prepared to make payments on debt.
Debt Structure
The second main consideration in assessing the creditworthiness of a municipality is the structure and types of long-term debt that it currently holds.
- Financial Instruments – Some instruments (generally those more atypical to municipalities) such as direct purchase agreements or private placements with third-party financial institutions may be beneficial for a variety of reasons. However, from a rating standpoint, they are often viewed to the municipality’s detriment. Many such obligations contain covenants that may apply financial restrictions to the municipality as well as acceleration clauses that could affect future cash flows. Furthermore, rating agencies generally see a lack of clarity and completeness in the financial disclosure of these arrangements as they are less typical in the municipal environment—further increasing the credit risk. It is critical that management be proactive in considering potential rating implications of becoming too highly leveraged with comparable types of debt prior to any such issuances as well as consider this during any long-term debt planning.
- Pension and Other Post-Employment Benefit Liabilities – For most municipalities these liabilities are not only some of the largest balances on the statement of net position but are also some of the quickest growing. As such, a comprehensive funding policy is recommended for these plans. Such a policy provides a roadmap by which the annual plan costs will be funded. In addition, such a policy will provide guidance on the municipality’s overall strategy regarding unfunded plan liabilities and will often show a plan for the systematic reduction, or maintenance at current levels (if appropriate), of the balance, as the trend information on these plans is a key consideration of the rating agencies.
While many aspects affecting a credit rating are out of a municipality’s control, active financial management and properly managed debt structure can be the difference between a highly or lowly rated city or town. No individual item is the sole determining factor when it comes to municipal credit ratings, but in the aggregate these attributes are consistently found to be common threads running through highly rated organizations. Additionally, they are routinely referenced by the rating agencies as areas given serious consideration during the determination.
