For cities, towns and villages across the country, a strong credit rating isn’t just a sign of financial health, it’s an important tool for maintaining long term stability, attracting investors and lowering the cost of borrowing (PDF). Local leaders might wonder what separates municipalities with top ratings, often referred to as ‘AAA,’ from those still working toward an upgrade. The criteria used to assess municipal credit worthiness can sometimes feel nuanced. Municipalities may not realize how much weight is placed on their own governance practices, risk management and planning for the future.
Speaking with Daniel Golliday, Associate Director, Local Governments – West at S&P Global Ratings, he explained “issuers with the strongest credit profiles have a lot in common when it comes to management practices and policies. When policies and practices are developed as part of a comprehensive risk management and mitigation plan, they generally enhance a government’s ability to manage through economic cycles and contribute to credit stability.”
Frameworks for Evaluating Local Governments
According to Golliday, S&P uses a specific set of criteria depending on the type of debt being analyzed, which can include general obligation bonds, utility debt, rental housing bonds, tax increment financing and more. Other key agencies, Moody’s Ratings and Fitch Ratings, have similar methodologies they utilize for these purposes. This is with the goal of maintaining consistent application and comparison across ratings in the U.S. and over time. As Golliday noted, “we strive for each rating symbol to represent the same level of credit worthiness for issuers and issues in different sectors at different times.”
S&P local government methodology is centered around a scored framework established for U.S. governments, which has five equally weighted credit factors: economy, financial performance, reserves, liquidity management and debt and liabilities. These factors form what S&P refers to as the individual credit profile.
In addition to these five factors, S&P also analyzes an institutional framework based on the state where the local government resides. This framework, which can be found in table 3-5 of S&P Global Ratings publication Methodology for Rating U.S. Governments, reviews the formal rules, laws, practices and customs of the region focusing on three subfactors: predictability, revenue/expenditure balance and system support and transparency and accountability. Each subfactor includes a criteria table which gives an assessment of 1 to 6 according to where the locality aligns with the standards listed. This could mean that the highest possible rating for a city in one state might be limited compared to a similar city in another state due to strengths or relative weaknesses in their institutional framework.
Key Practices of Top-Rated Municipalities
From Golliday’s experience and observations at S&P Global Ratings, the cities that consistently earn and maintain a higher credit rating showcase a set of shared characteristics. While financial performance is an important factor, qualitative factors like a city’s management and governance also impact their credit assessment.
Municipalities working towards a higher rating could focus on these practices that Golliday recognized as consistent among highly rated municipalities:
- Structured and balanced budget, including formal reserve policies.
- Strong liquidity management practices.
- Regular economic and revenue updates to identify shortfalls early.
- Establishing rainy day stabilization reserves.
- Prioritizing spending plans and establishing contingency plans.
- Strong long term and contingent liability management.
- Comprehensive multi-year financial planning.
- Formal debt management policy.
- Capital planning process that includes risk mitigation.
- Well defined economic development strategies.
Common Challenges to Achieving a Rating Upgrade
It might be tempting to assume a healthy fund or balanced budget would guarantee an upgrade for a city. However, Golliday expressed that S&P’s analysts take a more holistic view that includes a peer comparison. A municipality could look strong on paper but end up trailing behind its peers due to a lack of formal policies or if the city shows weaker practices in management. The ratings committee will also look at how an issuer compares with regional and national peers, which means that even good finances can be seen as weaker when in a side-by-side review.
Factors that could limit considerations of a rating upgrade can include:
- Use of cash accounting.
- Insufficient contributions to pension plans.
- Weak risk management culture and oversight, including inadequate internal controls.
- Persistent audit findings or unusual financial legal challenges.
- Limited contingency planning.
Additionally, Golliday noted that a limited economic base that is concentrated in one industry, broader macroeconomic conditions, inflation and monetary policy, can impact a local government’s credit rating even as they take proactive measures to improve.
Forward Progress
For local leaders hoping to upgrade their credit ratings, the key next steps could include prioritizing governance practices that align with good financial management, plan for the long term, and be proactive. Ratings reflect more than the fiscal condition of your city today: they show what a city has capacity for in the future.
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