Understanding S&P Ratings and Their Impact
You have likely heard that St. Helena recently received a downgrade by the Standard & Poor global rating’s agency (S&P). In the same spirit that I discussed CalPERS in last week’s blog post, it's essential to understand how S&P Global Ratings work and why they matter so much for municipalities like St. Helena. S&P Global Ratings is one of the leading credit rating agencies in the world, providing evaluations of the creditworthiness of various entities, including cities and municipalities.
S&P assigns ratings that range from AAA, the highest possible rating, down through several tiers to D (BB+ and lower are referred to as “Junk Bonds” aka risky bets with high interest rates to match), which indicates default. These ratings are crucial because they affect a city's ability to borrow money and the interest rates it must pay on its debt. A high credit rating, like AA+, indicates a low risk of default and generally allows a city to issue bonds at lower interest rates, reducing the cost of borrowing for public projects such as infrastructure improvements.
Conversely, a downgrade in the credit rating can have significant financial ramifications. It typically leads to higher interest rates on new bonds, increasing the cost of borrowing. Additionally, a lower rating can reduce investor confidence, potentially making it harder for the city to attract investment or refinance existing debt. In severe cases, a city with a low credit rating might face difficulties in accessing the bond market at all, limiting its financial flexibility.
Measure H Bonds: A Case Study in S&P’s Influence
Let’s use a specific example in our town. In 2022, the residents of St. Helena approved Measure H, a bond measure aimed at securing $19.15 million to fund critical water system improvements, including drinking water, stormwater, and sewage infrastructure. The success of Measure H was a pivotal moment for the city, promising much-needed upgrades to ensure the reliability and safety of its water supply, especially considering increasing drought risks.
The Measure H bonds were directly influenced by S&P’s credit rating. At the time of issuance, St. Helena’s AA+ rating meant the city could secure favorable interest rates on these bonds, thereby reducing the long-term cost to taxpayers. This strong credit rating reflected investor confidence in the city’s ability to manage its finances effectively, which in turn, made the bond issuance more attractive.
However, the recent shift in S&P’s outlook for St. Helena from stable to negative casts a shadow over future bond issuances. Unfortunately for the city, we have not yet issued all our measure H bonds—we have only issued $7.5 million out of $19.5 million in general obligation bonds. In real world terms, the general impact of just receiving a negative outlook can raise bond interest rates (residents/city pays this) by .10%-.50% (10 to 50 basis points) for these future bonds we will issue. If the city's credit rating were to be downgraded due to ongoing financial pressures—such as unfunded pension liabilities and potentially lower-than-expected revenue from the Farmstead Hotel (or no revenue at all, which looks increasingly likely)—$11.65 million tranches of bonds under Measure H will be subject to a further .25%-.75% impact. This will increase the cost of borrowing and place an additional financial burden on the city’s residents.
The Dangers of Drawing Down Reserves
One of the most critical aspects highlighted in S&P’s recent report is the danger of drawing down the city's financial reserves. Reserves are the financial cushion that allows a city to absorb unexpected expenses or revenue shortfalls without immediately needing to cut services or raise taxes. S&P and other rating agencies look closely at the level of reserves a city maintains as an indicator of financial health and resilience.
St. Helena has traditionally maintained a very strong reserve position, with available reserves exceeding 70% of operating expenditures in recent years. However, the city is now projecting significant drawdowns of these reserves to cover operational deficits and fund capital projects, potentially reducing the reserve level to around 30% of the budget by the end of fiscal year 2025.
While 30% is often considered a minimum threshold for a healthy reserve balance, drawing down reserves to this level—or below—can have serious consequences:
Increased Financial Risk: A lower reserve balance reduces the city’s ability to respond to unforeseen financial challenges, such as economic downturns, natural disasters, or unexpected expenditure increases. This heightened financial risk could lead S&P to downgrade the city’s credit rating, further increasing borrowing costs.
Negative Impact on Credit Ratings: S&P's negative outlook is partly driven by concerns over the projected depletion of reserves. If the city continues to draw down reserves without a clear plan to replenish them, the likelihood of a credit rating downgrade increases. A lower credit rating would make it more expensive for the city to issue bonds or refinance existing debt, compounding financial pressures.
Long-Term Financial Sustainability: Operating with a thin reserve margin limits the city’s flexibility to invest in necessary infrastructure, address rising pension costs, or respond to future financial crises. This could lead to a cycle of increasing debt and decreasing creditworthiness.
Replenishing Reserves: The Path to Stability
Given the risks associated with depleting reserves, it is crucial for St. Helena to explore strategies for replenishing its financial cushion. This could involve a combination of cost-cutting measures, revenue increases, and careful financial planning. Here’s how the city might approach this challenge:
Raising Revenue: The city could explore new revenue streams to replenish reserves. For example, the proposed real estate property transfer tax, if approved by voters, could generate substantial new revenue. A more comprehensive revenue plan is needed, and you can find it HERE
Restoring Financial Balance: Alongside raising revenue, it’s essential to ensure that the city’s operating budget is balanced. This might require re-evaluating and prioritizing expenditures, renegotiating contracts, or implementing cost-saving measures across city departments. The goal should be to generate surpluses that can be directed into reserves rather than continually relying on reserve drawdowns to cover deficits.
Setting Clear Reserve Targets: Establishing a formal policy to maintain reserves at a certain percentage of the budget—potentially higher than 30%—can help guide financial decisions and demonstrate to S&P and investors that the city is committed to maintaining its financial health. A well-communicated plan to rebuild reserves over time can also bolster confidence in the city’s fiscal management. Again, we need a comprehensive revenue plan to achieve this, amongst other town needs/wants.
For a detailed plan to do just that, please read my revenue plan based on sharing the burden HERE
What’s Next for St. Helena?
The negative outlook assigned by S&P Global Ratings serves as a stark reminder that St. Helena’s financial management will be under intense scrutiny in the coming years. To avoid a downgrade, the city must take proactive steps to address its projected deficits, potentially by cutting costs, finding new revenue sources, or re-evaluating its financial commitments and preferably all three.
The potential absence of revenue from the Farmstead Hotel, combined with unmet pension obligations that we covered in last week’s blog post, could push the city into a deeper financial hole. As a result, St. Helena’s leaders will need to make difficult decisions to stabilize the city’s finances and restore investor confidence. Residents will need to support them.
For residents and stakeholders, the situation underscores the importance of closely monitoring the city’s financial health and advocating for sustainable financial practices that ensure long-term stability. St. Helena’s future depends on the ability of its leaders to navigate these challenges effectively, preserving the city’s unique charm while maintaining its financial integrity.
Hopefully you found this blog helpful in understanding some fairly complex subjects. Let me know what you think.
Appreciate you taking the time to write and post your blogs. The above may be basic to some and super informative to others. Either way, it's useful information to define the ratings and how they pertain to the situation we have found ourselves in.
Wow! Thank you for this very clear and concise explanation. So, in the past 2 years we have gone way downhill financially. What this tells me is that we need a whole new change in leadership and management, Thank you for running! This shows that you are exactly the right person at the right time to be on our City Council,
Aaron, Thank you for this accessible, thoughtful, precise explanation and its implications for the City of St Helena. Every single expenditure must be scrutinized and not simply given the rubber stamp by the City Council.