The Determinants of Municipal Credit Quality.

• Author: Lipnick, Linda Hird

This article focuses on the methodology that one bond rating agency, Moody's Investors Service, uses for rating general obligation, lease-backed, and revenue bonds. It also clarifies which factors are predominant in rating assignments and which factors drive a future rating upgrade or downgrade.

Issuers, investors, and intermediaries often ask rating agencies the same thought-provoking questions. These questions generally focus on which factors will be predominant in assigning a credit rating, which credit factors will most likely drive a future rating upgrade or downgrade, and how rating levels on proposed Certificates of Participation (COPs) and revenue secured transactions can be gauged. This article is a response to these questions, and it focuses on the factors that Moody's Investors Service examines for its public finance ratings.

Credit Factors

There is always some variation in credit factors evaluated, but in general, factors considered when assigning a credit rating cover four primary areas: economy, debt, finances, and administration/management strategies.

Economic Factors. The economy, while probably the least controllable of the four credit factors, remains critical to credit analysis because the economic base is what ultimately generates the resources to repay municipal debt. Analysts assess the current economic profile and gauge specific economic strengths and weaknesses in an effort to better understand and set expectations for future performance. Ultimately, a clear vision of an issuer's current economic profile coupled with anticipated future economic trends is a key credit measure. Analysts consider the credit quality and market position of a region's largest employers, and the strength and diversity of its largest taxpayers. Public finance analysts consult regularly with analysts in the corporate finance group for information on the performance of an issuer's largest corporate employers or taxpayers.

Demographic and other economic statistics also are evaluated in order to assess the vitality of an area's economy. A diverse economic base (one that is not highly concentrated in a single employer or type of industry) is more likely to steadily expand and keep pace (or even exceed) with the national economy. An economy that is highly dependent on a cyclical industry may periodically surge, stagnate, or even experience declines. Unemployment rates are one of the most current measures of an area's economic health. Unemployment trends over time demonstrate a municipality's ability to withstand changes in the national or regional economy and may provide an indication of future employment performance. Other indicators of economic growth (i.e., retail sales, building permits, employment data, etc.) are especially critical in this evaluation. The type of economic statistics examined for any credit will vary, depending upon the forces that drive the area's economy.

When examining an issuer's ability to tap resources to support debt and pay for services, the extent of a community's overall wealth also is evaluated. Although no single aggregate measure fully quantifies a community's wealth, the full value per capita--which is the full valuation of taxable property divided by a given population--is an important indicator. In addition to these figures, trends in full value are examined along with full value relative to such factors as a community's population and debt outstanding. This allows analysts to gauge the leveraging of the local tax base and the residents and businesses paying the tax bills.

The resident population's socioeconomic characteristics also are evaluated using data from the U.S. Census Bureau and various state agencies. One of the most useful statistics for determining an area's economic well-being is per capita and median family income. Because significant variations in state and regional cost-of-living exist, it is important to compare these figures with both state and national averages.

Debt Factors. With every new issuance of debt, the issuer's debt position is reevaluated in order to determine the impact of the increased debt on credit quality. In rating debt, analysts calculate numerous ratios (see Exhibit 1). For general obligation tax-supported or general fund-supported debt, analysts evaluate all the debt for which the issuer's tax base or citizens are the source of repayment, whether or not that issuer actually issued the debt. Therefore, overlapping debt is considered to determine the overall debt burden to the taxpayers.

Overlapping debt is debt issued by municipal entities that have geographic boundaries that overlap (in part or whole) those of the issuer. For example, the debt of a city within a given county will be considered as overlapping debt for that county because the same tax base is responsible for supporting the debt. For measuring the burden of all tax-supported debt on the tax base, "overall net debt" is considered. Overall net debt excludes self-supporting debt that is unlikely to be paid from the tax base itself because it has its own revenue stream (i.e., from water and sewer fees or other self-supporting enterprise earnings).

In general, counties have the lowest debt ratios among the three primary groups of issuers (counties, cities, and school districts). This is because even though underlying debt of cities and school districts is considered, counties often contain unincorporated areas that provide some support to the tax base but are generally not authorized to issue debt.

Debt structure is another area of focus when examining the issuer's credit profile. Debt characteristics such as the amount of short-term debt an issuer has outstanding, the extent of reliance on variable rate debt obligations, and the overall structure of debt service payments are examined.

One key debt factor is the rate of debt repayment or payout. This statistic measures the rate of principal retirement within a given period of time and can sometimes be indicative of an issuer's willingness to pay. If retirement is rapid, the issuer may be viewed as very willing to draw upon its resources to pay its obligations. Conversely, if debt is structured for a very slow payout, the opposite may be true. Debt structure, including the rate of retirement, also can reflect such considerations as debt limits, future borrowing plans, and political factors related to tax levies. As a general rule, issuers usually structure their issues so that all debt is repaid within the useful life of the asset(s) being financed.

Financial Factors. Financial analysis involves a great deal more than just reviewing year-end financial statements. Although statements of operating results and year-end financial position are important, they reflect only a snapshot of time; these indicators only have analytic significance when placed in a proper context. For example, a large budget surplus may appear impressive, but could actually have negative implications if it results from a municipality's inability to execute certain spending programs, or results in taxpayers' taking legislative action to limit taxation. Conversely, a planned draw-down of a prior surplus (particularly to fund one-time expenditures such as capital or Y2K projects) may not signify fiscal problems. In fact, an established trend of financial performance and control is more important than year-end figures alone. Budgetary planning and projecting, in conjunction with daily spending control, as well as an issuer's policies on spending growth, use of surplus, and shortfall cont ingency plans are all incorporated into credit analysis.

One financial statistic that is key to evaluating financial strength is the general fund balance as percent of revenues. This ratio provides a measure of the financial reserves potentially available to fund unforeseen contingencies. The level of fund balance should be related to the likelihood that such reserves will be needed, as well as the issuer's revenue raising flexibility. Larger balances may be warranted if budgeted revenues and expenditures are economically sensitive or...