This is the second in a series of posts on the essential role of financial reserves in higher education.
For large capital projects—construction of a new student union, for example, or renovation of existing student housing—issuance of tax-exempt debt is one of the most affordable ways for not-for-profit colleges and universities to finance the project. The affordability of that debt is, however, partly contingent on the institution’s ability to maintain a strong credit rating, and unrestricted financial reserves are a significant component of that credit rating. In this month’s blog, we look at the link between unrestricted financial reserves and credit ratings and offer some considerations for effective credit management.
The purpose of credit ratings
Municipal bonds—which are issued by a state, city, county, or other governmental entity—are the most common form of tax-exempt debt. There are two basic forms of municipal debt:
- General obligation bonds are backed by the full taxing power of the issuing municipal authority and are considered relatively low risk. Depending on state law, some public universities may have authority to issue general obligation bonds. Other institutions—including private not-for-profit colleges and universities—cannot issue general obligation bonds and must look to revenue-backed bonds instead.
- Revenue-backed bonds are backed by the ability of the borrowing institution to meet its obligation to make principal and interest payments through the revenue it generates over the life of the bonds. The bonds are typically issued through a “conduit” issuer (i.e., a qualifying municipal or governmental authority), but the borrowing institution is responsible for repayment of the principal and interest on the debt. Because revenues can be disrupted by any range of factors, revenue-backed bonds carry a higher risk for investors than do general obligation bonds.
When determining whether to invest in revenue-backed bonds, investors will look to the credit rating of the underlying, borrowing institution. Credit ratings—issued by one or more of the three major credit rating agencies (Fitch Ratings, Moody’s Investors Service, and S&P Global Ratings)—provide an assessment of the probability that the college or university will be able to meet the terms of the debt obligation. These ratings are tiered. A credit rating in the AAA tier is better than a credit rating in the AA tier, which is better than a rating in the A or BBB tier. Ratings below the BBB tier are considered sub-investment grade. Institutions with a sub-investment grade rating can still access various forms of debt, but the amount of debt they can access generally will be lower, the cost of the debt will be materially higher, and the covenants that lenders require will be more stringent than for investment-grade rated institutions.
Unrestricted financial reserves and credit ratings
The absolute and relative levels of an institution’s unrestricted financial reserves are among the most important factors on which credit rating agencies focus in assessing a potential credit. This is because these indicators reflect both the institution’s current wealth and its ability to withstand serious disruption to its operations and cashflow. A variety of metrics are used to measure the relative strength of unrestricted financial reserves given the often complex structure of college and university unrestricted investments and endowments (restricted). Moody’s, for example, uses a variety of metrics to measure the strength of an institution’s reserves. These measures include Monthly Days Cash on Hand (unrestricted cash and investments that can be liquidated within one month), Annual Days Cash on Hand (unrestricted cash and investments that can be liquidated within one year), Spendable Cash & Investments (wealth that can be accessed over time or for a specific purpose, excluding permanently restricted cash and investments), and Total Cash & Investments (an institution’s total wealth, including the wealth of affiliated foundations).
The rating agencies issue median values for the various metrics they use to determine credit ratings. Median values for financial reserve metrics increased significantly across most rating categories for all three agencies in 2020 and 2021; this reflected the temporary inflow of pandemic relief funding and strong investment returns. The rating agencies’ outlook for the immediate future, however, is decidedly less promising. Moody’s has revised its industry outlook for higher education from stable to negative; S&P has a “stable but bifurcated” outlook, with less selective, regional institutions expected to face growing challenges; and Fitch’s outlook for the sector is “deteriorating.” While these industry outlooks do not translate into credit downgrades for every higher education institution, they do indicate a heightened level of scrutiny by the agencies of the comprehensive financial strength of each institution.
In the current environment, many institutions will experience operating deficits or shortfalls versus their originally projected results. In the short run, these organizations will need to rely on their unrestricted financial reserves (either directly or through the income they generate) to meet cash flow needs for operations and capital investments. If this situation is prolonged, the pressure on financial reserves will limit financial flexibility and reduce capital access in part due to credit downgrades.
Diminished reserves ultimately have a direct effect on access to capital and institutional debt capacity. If reserves are materially diminished without a cogent plan to regenerate them, the institution is likely to be faced with a downgraded rating. As a result, it will likely pay a higher interest rate and endure more stringent financial covenants on future debt than it would have if it had maintained its former rating. While the difference in rates between credit rating tiers may currently be relatively small, a rate differential of three-fourths of a full percentage point (75 basis points), for example, represents a significant additional cash flow burden of higher interest costs.
Unrestricted financial reserves and the funds they generate—including investment income—also are key factors in the quantification of an organization’s debt capacity (i.e., the amount of additional debt an organization can support without jeopardizing its current credit rating). This impact can be illustrated based on two key ratios:
- The first is total unrestricted reserves to debt (expressed in higher education with ratios such as Spendable Cash & Investments to Total Debt). This measurement of the balance between debt and unrestricted reserves is a risk measure (from an investor perspective) assessing the institution’s ability to pay down its debt if operations are disrupted. The stronger this ratio is, the more latitude a college or university has to take on additional debt, especially if the organization is toward the middle to top end of its rating tier.
- The second ratio is the debt service coverage ratio. This ratio measures the institution’s ability to make principal and interest payments with funds derived from both operating and non-operating (e.g., investment income) activities. A higher ratio here means that the institution has more funds available to service its current and prospective debt. The debt service coverage ratio is much more volatile than the balance sheet ratios as it is tied to operating results, but it is also a more accurate measure of an institution’s real debt capacity. Simply said, if the institution can’t meet the debt service cash flow requirements, it can’t afford the debt. In such a situation, the balance sheet becomes secondary.
The ability to assume additional debt is an important safety valve if, for example, an institution needs to mitigate inadequate short-term financial performance to fund ongoing or strategic needs. Managing both the quality of operations and the balance sheet are key to maximizing access to external capital.
Credit management considerations
A strong credit rating clearly carries many benefits, and institutions should strive to ensure that they are taking the steps necessary to protect that rating. This means maintaining a continual focus on managing expenses, regular review of academic program performance and enrollment trends, and ongoing efforts to grow revenue. The balance sheet—and the unrestricted financial reserves it contains—are the foundation of an institution’s credit.
That being said, institutions should not consider their rating status as a hill to die on. Institutions that have secured a strong rating can be justly proud of their achievement. However, the strength of that rating must always be weighed against the strategic goals and financial needs of the institution. A credit rating should not be preserved at all costs if doing so means that important projects and strategies for growth will not be funded. Drawing down financial reserves in the short term might be justified, provided that the institution has and will implement a comprehensive financial plan that defines a road map to stabilize and rebuild those reserves.