On April 1, 2020, the S&P Global Ratings Agency (S&P), announced a negative outlook on the entire U.S. public finance sector reflecting the economic damage from COVID-19. As a result, issuers are likely asking, “What rating impact should I expect as a consequence of COVID-19? First, it is important to clarify that S&P’s action did not directly affect any individual outstanding ratings. Each issuer and debt security will be individually evaluated for potential rating impact. The rating agencies will prioritize these reviews by level of credit risk, and liquidity will be the near-term focus.
S&P’s announcement serves as a signal to the public finance market that increased expenditures and decreased revenues will occur in a stressed credit environment and that “more negative than positive rating actions” are likely. While S&P’s action across all public sectors brought to light the scrutiny that rating agencies are placing on issuers, it is important to maintain perspective. For instance, S&P has issued a negative outlook on higher education for three years, but we have not seen wholesale downgrades within the sector.
With tens of thousands of U.S. public finance ratings, the agencies are triaging issuers to first review for potential rating impact. Hospitals, airports, mass transit and higher education are sectors with elevated risk.
For general government issuers, the following characteristics will rise to the top of the pile:
Bonds with these credit characteristics are generally rated lower, reflecting the implicit credit risk. However, the balance sheet and revenue risks from the current economic downturn may exceed the expected stress scenarios of the rating agencies.
Across all sectors, the immediate focus is on liquidity. Accurately projecting the inflow and possible disruption of revenue collections and tax distributions are critical. Comparing these to the timing of expenses, both routine and new expenses necessitated by COVID-19 will create a clear cash flow picture. In some cases, short-term liquidity crunches may stem from delays in revenue or extra expenditures and cash flow borrowing may be necessary. Cash flow borrowing is unlikely to result in rating action, provided that the issuers demonstrate ability to repay the short-term financial obligations once revenues are available.
Effective management of new and existing costs will be a favorable factor when ratings and issuers are under review by rating agencies. Certain expenses related to COVID-19 may be reimbursable by the federal or state government and keeping track of expenses associated with the pandemic will demonstrate not only effective management but will also prove useful when seeking reimbursement in the future.
Issuers with a strong balance sheet will be insulated from the economic downturn and rating pressure. High levels of liquid reserves provide cushion for uneven cash flows and allow the government to use fund balances to offset the budget.
Issuers will benefit from planning now, not only to help respond to rating agency inquiries, but more importantly, to prepare to maintain or rebuild financial stability.
Working with the rating agencies in this new environment is not tremendously different than under normal circumstances. Firstly, an entity should proactively provide a free flow of information. Keep your rating analyst up-to-date on your COVID-19 response, sharing both negative and positive information. Secondly, prepare for your conversations. Ask your municipal advisor to give you an idea of what questions you may be asked. Have a solid handle on cash flows and be prepared to explain and demonstrate plans to rating agencies, including the potential need for cash flow borrowing. Finally, consider what could go off track within your COVID-19 plan and have a plan B – and maybe even a plan C –ready. Not only is this a valuable management practice, it will also help keep the rating agencies positive on your credit quality.
For more information on this topic, or to learn how Baker Tilly Municipal Advisors can help, contact our team.