In our experience, issuers with the strongest credit profiles have a lot in common when it comes to management practices. Although S&P Global Ratings' rating criteria for state and local governments is founded in quantitative measures, the importance of management and governance as part of the qualitative factors we analyze heavily informs our credit analyses. ESG credit drivers can also be found in both qualitative and quantitative factors, and the kind of advanced planning and risk mitigation necessary to address ESG pressures often overlap with the policies and practices many highly rated governments have in place.
Management's policies and decision making can positively affect ratings and our view of management factors, administrative characteristics, and other structural issues facing a government. We continue to employ our Financial Management Assessment (FMA) criteria, which offers a more transparent assessment of a government's financial policies and practices. Outside the specific measures of the FMA, we view management and governance as significantly contributing to many of the individual credit ratios that are the foundation of our quantitative analysis.
Decisive planning and action by management will be critical as issuers face evolving ESG risks and ESG topics take a more prominent role in management conversations. As a result, we have updated our Top 10 Management Characteristics list with an eye toward the emerging ESG risks that governments may face in coming years.
The ESG Umbrella Lets More Light In
While we have enhanced the article with ESG commentary, the premise remains the same: practices developed as part of a comprehensive risk management and mitigation plan generally enhance a government's ability to manage through downturns and contribute to credit stability. We expect similar proactive planning as governments address ESG risks. While many ESG factors are not new to government issuers, the discussion of them under the ESG umbrella provides additional transparency for market participants.
This list of the "Top 10" management characteristics associated with S&P Global Ratings' highly rated borrowers is most applicable to state and local governments, but the relative importance of each may vary between issuers. In our view, identifying challenges or issues in advance and making plans to address them helps establish credibility and provides greater transparency in the rating process.
1. Focus on structural balance
In our view, a structurally balanced budget is an essential characteristic of highly rated credits. From S&P Global Ratings' standpoint, a budget is balanced if recurring revenues match recurring expenditures. In evaluating whether a budget is balanced, we analyze the underlying revenue and expenditure assumptions. Optimistic revenue or expenditure assumptions, such as recurring reliance on debt restructuring for budgetary savings, deferral of ongoing expenditures or infrastructure requirements, insufficient funding for retirement liabilities, and saving assumptions that have significant implementation risks, color our view of whether a budget is balanced or not.
2. Strong liquidity management
Ultimately, the possibility of having insufficient resources to meet debt obligations is central to our credit analysis. Management's ability to manage its cash flow and identify potential issues, internal or external, is essential to ensure full and timely payment of debt service. In our view, potential for inadequate liquidity serves as a bellwether to the risk of immediate and potentially severe credit deterioration, particularly for those with significant budget misalignments or contingent liquidity exposure. In the few instances where state or local governments may encounter genuine credit distress it is likely accompanied and possibly exacerbated by problems with liquidity. Access to additional sources of internal or external liquidity and a plan on how, when, and in what amounts to access these, are a credit positive. Some obligors' debt profiles include liquidity risk exposure tied to variable-rate demand obligations and alternative financing products. We have found that management teams of highly rated credits fully understand the risks assumed in the debt portfolio presented by these structures and are able to limit, mitigate, or develop a careful plan to manage the potential exposure to these liquidity demands.
3. Regular economic and revenue updates to identify shortfalls early
In our experience, having a formal mechanism to monitor economic trends and revenue performance at regular intervals is a key feature of stable financial performance. This is particularly true in the case of states that tend to exhibit revenue declines during economic downturns because they rely on personal income tax, sales tax, corporate income tax, and other economically sensitive sources. This is in contrast to many local governments that rely predominantly on property taxes. We believe that evaluating historical performance of certain revenues is important because each government will have different leading or lagging economic indicators that signal potential revenue variance based on its economic structure. The earlier revenue weakness is identified in the fiscal year the more effective the response to budget balancing; it is also important to evaluate surges in revenues to determine if the trend is an aberration or may be sustained.
4. An established rainy day/budget stabilization reserve
A formalized financial reserve policy is a consistent feature of most of S&P Global Rating's highly rated credits. In our view, reserves provide financial flexibility to react to things like budget shortfalls, unexpected environmental events, or other unforeseen circumstances in a timely manner. No one level or type of reserve is considered optimal from S&P Global Ratings' perspective. Our analysis of reserve sufficiency relies more on what governments determine based on their own needs. Some important factors government officials generally consider when establishing a reserve are:
- The government's cash flow/operating requirements
- The historical volatility of revenues and expenditures through economic cycles
- Susceptibility to contingent liquidity provisions in alternative financing documents
- Whether the fund was created as a formal or informal policy, and/or if it is a legal requirement
- Whether formal policies are established that outline under what circumstances reserves can be drawn down; and
- If there is a mechanism to rebuild reserves once they are used.
Reserves are in place to be used in a time of need, so in our view the use of budget stabilization reserves is not always a credit weakness. However, full depletion of reserves in one year without other budget adjustments can create a structural budget gap so the context in which reserves are drawn down and plans in future years is important.
5. Prioritized spending plans and established contingency plans
Contingency planning is an ongoing exercise for most highly rated governments. Prioritized spending and contingency plans have always been important risk management tools. In our analysis, we consider whether a government has contingency plans and options to address changing economic conditions, intergovernmental fund shifts, budgetary imbalance, or other emerging risks that may require resource allocation. Emerging risks include many ESG risks, including cyber security, natural disasters, infrastructure deficiencies, and deferred maintenance. We note that risks facing governments may be different and evolve over time; thus, governments that focus on longer-term planning are better positioned to respond swiftly, particularly if the plans are subject to regular monitoring.
6. Strong long-term and contingent liability management
In our view, recognition and management of long-term and contingent liabilities are characteristics of highly rated credits, and we incorporate governmental liability management into our rating analysis with an emphasis on how liabilities are managed over time. In particular, we view pension and other postemployment benefit (OPEB) obligations as long-term liabilities that may require active management. While the funding schedule for pension and OPEB can be more flexible than that for a fixed-debt repayment, it can also be more volatile and may cause fiscal stress if not well managed. The size of the unfunded liabilities, annual costs associated with funding them relative to the budget, credibility of assumptions, and funding discipline are all important credit factors in our review of state and local governments. We differentiate credits where long-term liabilities are large and growing, particularly when contributions are less than required and there has been limited action on reform initiatives, all of which point to a weaker management approach.
Outside the general fund, there are other areas of operations and services than can create budget pressures and increase contingent liabilities if not properly managed. Stadiums, convention centers, health care entities, and other enterprise operations can cause funding challenges for governments even when there is no clear guarantee or legal responsibility for the government to provide funding. For issuers backing these kinds of non-traditional debt financings, or bank loans with permissive covenants, we view a debt management plan as more critical to actively monitor the potential for unanticipated payments.
7. Comprehensive multiyear financial planning
As mentioned above, a balanced budget is a characteristic of highly rated governments but maintaining balance is often a challenge. Government officials must address out-year budget imbalances but may be constrained by practical limitations of raising revenue or cutting expenditures even when legal authority exists for both. Having detailed information on costs associated with various policy decisions creates greater transparency, particularly when incorporated into a comprehensive multiyear plan. We realize that the out-years of a multiyear plan are subject to change, but feel they can still provide a model to evaluate how various budget initiatives affect revenues, spending, and reserve levels in order plan for fiscal balance.
8. A formal debt management policy
Debt affordability guidelines or models generally include a systematic review of existing and proposed debt, and how they will affect a government's future financial profile. In many cases, these policies address exposure to variable-rate debt, swaps, and other contingent liabilities, all of which we view as important to understand and evaluate potential future pressure. They can also include criteria for when refunding bonds are allowed, amortization periods, and what types of projects can be funded through debt issuance. The affordability measures are typically tied to a government's revenues or expenditures, debt per capita, and debt as a percentage of either gross state product (states) or market value (local governments). The impact of these policies on a credit rating will depend on our view of how the government establishes and uses the policies, and the track record in monitoring or adhering to the affordability parameters established in the policies, especially during economic downturns. We believe the process enhances the capital budgeting and related policy decisions regarding debt issuance and amortization, keeping leverage levels in focus.
9. A capital planning process, including risk mitigation
A government with a comprehensive assessment of capital and infrastructure requirements, including risk management and deferred maintenance, will be better positioned to manage these requirements over time in the most cost-effective way. Neglecting critical capital needs may contribute to higher future costs and impede economic growth, endangering future revenue generation. A capital improvement plan with funding needs as well as anticipated sources is a useful planning tool for determining future borrowing needs and assessing affordability.
10. A well-defined and coordinated economic development strategy
In addition to historical economic trends, we consider economic development initiatives and future growth prospects as they are likely to affect future revenue-generating capacity. Effective economic development programs typically take a long time to implement and may involve some resource commitment. A plan that includes a cost benefit analysis and tracks outcomes can provide meaningful information for governments when evaluating the level of resource allocation. If these economic development programs and strategies create employment, income growth and diversification that leads to a net revenue benefit to a government, we could view that favorably.
This report does not constitute a rating action.
|Primary Credit Analysts:||Jane H Ridley, Centennial + 1 (303) 721 4487;|
|Nora G Wittstruck, New York + (212) 438-8589;|
|Geoffrey E Buswick, Boston + 1 (617) 530 8311;|
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