Philadelphia Schools Lure Buyers as Budget Erodes: Muni Credit
Philadelphia’s school district, the nation’s eighth-largest, is in such desperate shape that it plans to sell $300 million of bonds this week to plug a deficit. Yet investors hungry for yield have fueled a rally in its debt.
The district of about 203,000 students faces a $1.35 billion shortfall over the next five years and may close a quarter of its schools. It is resorting to deficit financing for the first time since 2002. And as in most of the U.S., public schools in the nation’s fifth-largest city are receiving less state funding per student than in 2008, according to the Center on Budget & Policy Priorities in Washington.
Even with the fiscal stress, Philadelphia school debt is drawing investors facing interest rates near 45-year lows. The extra yield buyers demand to own district securities has dropped by about a quarter since January, data compiled by Bloomberg show. One lure is that state aid pays the bonds directly through a so-called intercept program.
“The intercept is powerful and it offsets the crappy credit quality of the Philly school district,” said Alan Schankel, director of fixed-income research at Janney Montgomery Scott LLC in Philadelphia.
By diverting state aid to school debt, the intercept program bypasses the district and boosts protection for investors. The Philadelphia school debt will be issued through the Pennsylvania State Public School Building Authority. The sale is set for as soon as tomorrow.
Given the program, the deficit-financing bond is rated Aa3 by Moody’s Investors Service, its fourth-highest grade, and AA by Fitch Ratings, third-highest. The district’s underlying credit is rated Ba1 by Moody’s, one step below investment grade. Fitch on Oct. 16 cut it one level to BBB-, one step above junk, saying the deficit sale showed its “ongoing challenge to maintain even a minimal level of reserves.”
The district’s spending gap has swelled from $1.1 billion in May. It is facing escalating costs from areas such as pension contributions and funding for charter schools.
A Philadelphia school bond sold under the intercept program and maturing in 2038 traded at an average yield of 3.18 percent on Oct. 1, data compiled by Bloomberg show. Its yield spread above top-rated munis has averaged 0.41 percentage point since the start of September, compared with 0.54 point in January, data compiled by Bloomberg show.
The Federal Reserve’s policy of keeping its benchmark overnight rate near zero is helping spur investment in higher- yielding, riskier assets. The extra yield buyers demand on 10- year general-obligation bonds rated BBB, the second-lowest investment grade from Standard & Poor’s, was 1.11 percentage points last week, close to the smallest since 2008, data compiled by Bloomberg show.
Across the nation, 26 states are distributing less funds to elementary and high schools in the 2012-2013 school year than they did last year, and 35 are spending less on schools than in 2008 when adjusting for inflation, according to the Center on Budget & Policy Priorities, a nonprofit focusing on issues affecting lower-income Americans.
Moody’s expects Pennsylvania local-government downgrades to exceed upgrades through early 2014 and said that school districts “are most at risk given their rapidly rising pension costs, flat state aid projections” and a property-tax cap, according to a report by Michael D’Arcy, an analyst for the company in New York.
Fernando Gallard, a school district spokesman, said officials declined to be interviewed before the sale.
Using long-maturity debt to pay current expenses is uncommon for school districts, said Geordie Thompson, a Moody’s analyst in New York who said his company didn’t track such sales.
“It’s very indicative of fiscal stress: borrowing in the capital markets over an extended period of time to pay for one year’s deficits, in essence,” he said.
The Philadelphia district sold $300 million of deficit- financing bonds through the state intercept program in 2002, according to Moody’s.
Adam Weigold, who manages $1.2 billion of munis at Eaton Vance Corp. in Boston, said he expects the district to find ready buyers for the bonds, which he will consider purchasing, in part because of the protection to investors.
Bond managers may also be attracted to the chance to buy the Philadelphia school debt as a way to diversify their portfolios. The sale may be the last for five years, said Thomas Knudsen, the district’s chief recovery officer, in a letter last month accompanying the financial plan through fiscal 2017.
“A deficit borrowing is an extraordinary action that we will not be able to undertake again in this planning horizon,” he wrote in the letter, sent to the School Reform Commission, a board appointed by the mayor and Pennsylvania’s governor to run the schools.
Knudsen estimated that the sale will add about $22 million annually to the district’s debt burden.
The commission is holding public meetings to discuss its plan to shut a quarter of 249 facilities by 2017, saying a third of the building space isn’t being used. A decision on the proposal isn’t expected this year, Gallard said.
Charter schools have added students, siphoning funds available for district institutions.
A projected 29 percent of students will attend charter schools in fiscal 2013, compared with less than 10 percent in 2003, and additional state aid for charter-school reimbursement ended in fiscal 2012, Moody’s said.
Meanwhile, expenses are rising, with the district’s pension costs more than tripling from 2012 to 2017, according to Fitch.
The school district must overhaul its finances, Weigold said.
“Taking on more debt is never a helpful way to restructure your balance sheet,” he said. “This is a credit that should not be borrowing.”
In the $3.7 trillion muni market last week, yields on benchmark 10-year tax-exempts rose about 0.03 percentage point to 1.68 percent, data compiled by Bloomberg show. Treasuries of similar maturity yielded about 1.77 percent at about 4 p.m. New York time on Oct. 19.
It was the third straight week that munis ended with yields below their federal counterparts. Investors look at the ratio to gauge relative value between the two asset classes. The lower it is, the more expensive munis are compared with Treasuries.
Following are pending sales:
NEW JERSEY plans to sell $2.6 billion of general-obligation tax-and revenue-anticipation notes through competitive bid as soon as Oct. 30, data compiled by Bloomberg show. It’s the state’s largest short-term note deal, the data show. (Added Oct. 19)
CALIFORNIA plans to sell about $550 million in general- obligation refunding bonds as soon as tomorrow, according to data compiled by Bloomberg. The debt will be sold via auction. (Updated Oct. 22)
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