A Look at Manchester’s Bond Rating Downgrade and why the Tax Cap is not to blame.
August 8, 2013
Last week the City of Manchester saw its general obligation bond rating downgraded from Aa1 to Aa2; in layman’s terms it went from the second highest to the third highest ranking category affecting $193 million in outstanding general obligation (GO) debt. The bond rating agency Moody’s also downgraded the school facility revenue bonds to Aa3, affecting $77.3 million in outstanding bonds.
The long term outlook for the city’s debt was also changed from negative to stable, indicating that further downgrades are unlikely.
Many have blamed the recently enacted tax cap for the downgrade and Moody’s opinion does mention it, noting that “(t)he rating also incorporates the city’s currently satisfactory financial position, which has been pressured by the recent implementation of a local tax cap.”
But is the tax cap really to blame for the downgrade? The key to the rating downgrade is the size of the city’s reserve fund, which dropped below 20% of revenues due to the recession and the sluggish recovery’s impact on tax collections. While a tax cap can limit the ability of the city to rebuild those reserves, the real culprit is the Recreation Fund.
The Recreation Fund, which consists of McIntyre Ski Area (which has been leased to a private group since 2009), a pair of ice arenas, and a golf course, have been operating in deficit for several years, requiring the transfer of a total of $5.8 million from the city’s general fund, with the understanding that it be repaid. The Recreation Fund currently carries this amount on its balance sheet as ‘due to other funds’. Given the nature of the debt, Moody’s considers it very unlikely that the city will recoup this money from the Recreation Fund and therefore factored in the write off for the full amount against the General Fund reserves.
Of this write off, Moody’s notes, “while the liability to the General Fund is limited given the size of the fund, the adjustment to the fund balance nonetheless brings reserves to levels below the current rating category.”
This means that the downgrade would have happened with or without a tax cap in place. The write off of the Recreation Fund deficit, which reduced the city’s Reserve Fund below the threshold for holding onto the Aa1 rating, is solely to blame. Had the tax cap not been in place there is a possibility that the outlook may have been rated positive rather than stable, but that would purely be speculation. Of the factors that could increase the city’s rating, two are directly related to the pressures placed on the city by the Recreation Fund, with the third being sustained economic growth.
Furthering the point, the last rating given by Fitch, another bond rating agency, less than a year ago mentioned the tax cap as likely to limit budget flexibility but concluded that “the impact of the cap on the city’s creditworthiness is presently neutral”
I question a statement in the first paragraph: “… affecting $193 million in outstanding general obligation (GO) debt” and “…affecting $77.3 million in outstanding bonds.”
Existing debt is not affected. The interest rate on those bonds was established when those bonds were issued. The amount the city must repay and the interest to be paid have not changed.
The change in a bond rating only affects what interest rate might be required for bonds to be issued in the future.
Am I wrong? Did the city of Manchester somehow issue bonds with adjustable interest rates over the period of the bonds?
Hi Doug, thanks for your comment. You are right; once the bonds have been issued the rate is fixed, so the rate stays the same no matter how much the rating of the issuer might change. So despite the downgrade, Manchester will still pay the same amount on the existing bonds.
It does affect the secondary market however. Say an owner of Manchester’s bonds, who bought them at Aa1, now wants to sell them. The new Aa2 rating indicates greater risk, which would normally command a higher interest rate. Since the interest rate is fixed, the only way to compensate for the increased risk is to sell the bonds for less then their face value.
While this does not affect the issuer, the downgrade does affect the value of the existing bonds to investors.
Thanks for pointing this out though, it is an important distinction to make.
The use of ‘affected’ actually comes from Moody’s itself. Getting to the Moody’s site requires a login, so here is the relevant paragraph from the opinion:
“New York, July 30, 2013 — Moody’s Investors Service has downgraded the City of Manchester’s (NH) long-term general obligation rating to Aa2 from Aa1, affecting $193 million of outstanding debt. Concurrently, Moody’s has downgraded the city’s appropriation-backed school facility revenue bonds to Aa3, affecting $77.3 million of outstanding debt. The outlook has been revised to stable from negative.”