Rating agencies: When are they going to call and what are they going to ask?  

On the long list of issues to address emerging from COVID-19, credit ratings may not yet have risen to the top for most local governments. However, in the coming months, the agency that rates your bonds will be reaching out to understand the impact of the pandemic, and ensuing recession, on your entity. This article is intended to help local governments understand when you might expect that call, and provide a sneak preview of the questions you can expect to be asked.

When are they going to call?

Credit rating agencies are actively triaging which of their public sector ratings are most vulnerable to the impacts of COVID-19 and the subsequent recession. The first areas spotlighted were credits supporting revenues directly impacted by COVID-19 (sectors like transportation, hospitals and higher education). On the other hand, water and sewer revenue bonds have been viewed as low risk given the essential nature of these services. In fact, Moody’s just affirmed the stable outlook on the water and sewer sector.

Local governments have been categorized as moderate risk, but are increasingly coming into the focus of the agencies. The following characteristics will move local governments to the top of the list for review.

• Significant share of economically sensitive revenues
  Sales, hospitality and income taxes, as well as fees associated with economic development, are all directly tied to the health of the economy and quickly impact local governments’ income. If economically sensitive revenues make up more than 20% of revenues, it’s likely your entity will be at the forefront for review. If property taxes make up more than 75% of your operating revenues, your government is relatively well insulated from economic volatility and should not expect a rating review call in the next six months.
• Weak liquidity/reserves
  In the face of revenue shortfalls, a lack of cash and reserves means little cushion to fall back on in hard times. Depending on the revenue mix of your local government, reserve levels below 10% of revenues are likely to cause credit concerns, particularly for entities with a high share of economically sensitive revenues. Those with single-digit reserve levels have probably already had a rating check-in or should expect to have one very soon.
• Short-term notes
  Entities with short-term notes that are expected to be paid off with long-term financing present a market access concern. If the market is not functioning efficiently, the ability to sell long-term debt to repay the notes can become a problem. Volatility in the municipal market in late March/early April has raised the alarm that the market may not be there to issue debt. Expect a rating check-in at least 30-60 days before notes mature.
• High dependence on state aid
  States are experiencing their own budget challenges. One strategy used to address state revenue shortfalls is to reduce financial aid to local governments. Entities that have a high reliance on state aid (e.g., more than 30% of revenues) are a credit concern. Rating agencies are watching state legislatures carefully for local aid cuts. Expect a call from your rating analyst once discussion of state aid cuts gain traction in your state.
• Lower ratings
  Local governments with low ratings often display one or more of the aforementioned characteristics and/or other concerning factors, such as operation of a community hospital or the need for voters to approve the operating levy, as in school or other special districts. The rating agencies will expect entities rated in the BBB/Baa category and below to have more operating stress in the current environment. Expect a rating call in the next three months if your bonds carry a low-level investment grade or speculative grade rating.

What are they going to ask?

When it comes time to speak with the rating agencies, analysts will try to ascertain how much of a financial impact COVID-19 and the ensuing recession has had or will have on your financial viability. Fundamentally, the rating agencies will be trying to gauge the size of your revenue gap. Have you prepared for this? Have management and the governing body come to terms with the scope of the challenge, and have they developed a plan?

The following are questions you should be prepared to answer.

1. Which of your revenues do you expect to be impacted by COVID-19/the recession?
   -By how much are you projecting revenues to be reduced in this fiscal year and the next?
   -What information/indicators are you watching to help inform you on those projections?
   -Have you done any stress testing of your economically sensitive revenues?
   -Have you already seen drops in economically sensitive revenues? How do revenues compare to the same month last year?
2. Have you had any COVID-19-related expenditures in the current fiscal year?
3. What is the gap between revenues and expenses in the current and subsequent fiscal year?
   -What steps are you taking to close the gap?
   -Quantify those steps; how much of the gap do they close?
4. Do you expect to use a fund balance to bridge the gap between revenue and expenditure?
   -After using the fund balance, do you anticipate being in compliance with your fund balance policy?
5. Do you project cash flow over the course of the year?
   -Do you see any times when liquidity might become tight?
   -Do you anticipate any need for cash flow borrowing?
6. Are any of your major taxpayers closing or expanding as a result of COVID-19?
   -Are revenues at risk as a result?
7. Do you anticipate any policy changes as a result of COVID-19?

Finally, local governments should know that you do not have to deal with this on your own. Call on your municipal advisor to help you prepare for your conversation with the rating agency. The actual questions asked will be tailored to your organization and your advisor can help anticipate those.

For more information or this topic, or to learn about how Baker Tilly Municipal Advisors can help, contact our team.