From the issue dated February 7, 2003
Junk-Bond Colleges
Declining fiscal ratings reflect the struggles many small
colleges face
By MARTIN VAN DER WERF
The long-predicted decline in the fortunes of small private
colleges is
beginning to show up in the
bond market. Since the
ALSO SEE:
beginning of 2002, six
colleges have been
Fall in Value
downgraded to "below
investment grade," or "junk
Growing Pessimism
bond" status. The number now
rated in the junk category, 17,
has nearly doubled in the last
two years.
The reasons are familiar. Investments are performing poorly,
which has hurt endowments; the sinking economy is causing
parents to question the worth of the higher tuition at private
institutions; and debt that was taken on during the flush years
of the late '90s is now proving to be a drag on already thin
balance sheets.
To lure students, smaller colleges have been doling out more
financial aid and building new facilities to match those at the
college down the road. The result is that many colleges are
operating year after year with deficits, further depleting their
resources.
Once colleges have their bonds downgraded to junk status, it
creates uncertainty about their financial strength, and, in most
cases, it forces colleges to pay higher interest rates to the
holders of their bonds.
Nonetheless, investors, particularly those who make purchases
for mutual funds, remain interested in bond issues from lowrated small colleges. The bonds are a staple of tax-free highyield municipal funds. Only one college, Bradford, has
defaulted on its bonds in recent years. The Massachusetts
liberal-arts college closed in 2000 because of financial
problems. The possibility that more small liberal-arts colleges
might follow that same path, however, and fears that Life
University, a Georgia institution primarily known for its
chiropractic program, will default on its bonds, too, have sent
the first shivers through the higher-education bond market.
Barnet Sherman, who buys small-college bonds for Van
Kampen Funds, says he is focusing less on liberal-arts
colleges, and more on specialized colleges that he thinks will
remain popular.
"We look for schools that have a very important market
niche," says Mr. Sherman, a vice president and fund manager
for the New York-based mutual-fund company. "Liberal-arts
schools? I would say more generally that they have a harder
sell. People are looking at them more carefully, and
wondering what their long-term chances of success are." Van
Kampen is still buying bonds of some liberal-arts institutions,
like Bennington College, in Vermont. But it is spreading more
of its money to places like Daniel Webster College, in New
Hampshire, which specializes in aviation careers, and the
Boston Architectural Center and Montserrat College of Art, in
Massachusetts.
Terry J. Goode, a senior municipal credit analyst for San
Francisco-based Wells Capital Management, says, "We are
keeping an eye on [college bonds] we do own to make sure
they will be able to continue to perform. If this anemic
economy continues, they do risk further declines in credit
quality. I think 2004 will be a critical time for them if the
equity markets do not come around."
Financial Pinch
The bond markets offer an incomplete picture of the financial
health of all of American higher education. Only about 500 of
the 4,000 or so colleges and universities in the United States
carry a public bond rating. But on an individual basis, the
struggles of colleges with ratings offer a glimpse into the
serious financial pinch being felt
around the country, particularly in the Northeast and Midwest,
where most small private colleges are located. Many are in
spirals of accumulating debt and diminishing resources.
Eastern Nazarene College, in Massachusetts, for example, has
financial resources of about $4-million, but debt that exceeds
$22-million. At the University of Findlay, in Ohio, the debt is
$28.5-million, far more than the institutions' total financial
resources of less than $17-million. At Clarke College, in
Iowa, total financial resources have slipped below the
college's overall debt of $12.3-million within the last two
years. All are now rated one notch below investment grade.
Colleges that have been downgraded to "junk bond" status
wince at the implications of the rating, but say it is not
unusual in a bad economy, and reflects what is happening
with corporate bonds and some government bonds.
The report with the downgrade decision "is a good tool for
usit's interesting and important to look at it," says Eugene T.
Kirschbaum, vice president for business and finance at Clarke.
"But it shouldn't be taken as a sign that the college is falling
apart because it isn't falling apart."
Clarke used an $8-million bond issue in 1998 to build a new
student union and a student apartment complex. Both have
been open for three years now. They were added to a campus
that is made up of comparatively new buildings, since about
half of Clarke's campus was destroyed by fire in 1984. The
Roman Catholic college, which has about 960 students, has
been cutting costs by, among other things, reducing cafeteria
hours and negotiating new purchasing contracts.
"Unless something unforeseen happens, we will have a
balanced budget this year," says Mr. Kirschbaum.
That would be a marked change from recent years. According
to a review of the college's credit by Moody's Investors
Service, published last month, Clarke has averaged an
operating deficit of 6.4 percent for the last three years. The
college's saving grace has been fund raising. It has raised an
average of $3-million a year for the past three years, but the
college endowment is only about $10-million. That is because
some of the money given to the college is diverted straight to
the general operating budget, or to pay for building projects,
says Mr. Kirschbaum.
At Findlay, the drop in ratings is meaningful, but no reason to
panic, says Martin Terry, vice president for business affairs.
The financial problems "have really brought this university
together as a team to see what we could do, rather than just
cut positions and cut programs," says Mr. Terry. "We'll just
get in there, and do the things we need to do to straighten this
out, and in two years, we'll reapply" for a rating review.
Findlay, however, appears to be in worse financial shape than
it was three years ago, and Moody's "believes that the recent
erosion of balance-sheet resources is unlikely to be reversed
over the near term," according to a credit report released in
November. The college has been running deficits for five
consecutive years, and total financial resources have
plummeted by more than 40 percent since 1999.
How the Ratings Work
Colleges are rated on the same scale as other bonds. The
highest rating, AAA, goes only to the wealthiest colleges and
state-university systems. The AAA institutions include five of
the eight Ivy League members (Dartmouth College and
Columbia, Harvard, Princeton and Yale Universities), other
large national universities, such as the University of Notre
Dame and Stanford University, and smaller institutions with
extraordinary financial resources, such as Amherst and
Grinnell Colleges.
In descending order from AAA, there are three categories of
AA ratings, three of A, and three of BBB. Below BBBñ, in
the case of Fitch Ratings and Standard & Poor'sor Baa3, as
Moody's expresses ita college is considered "below
investment grade" or "speculative." That category, made
popular by such traders as Michael Milkin and Ivan Boesky,
became known as "junk bonds" in the 1980s.
The ratings continue: Three BB ratings, then three B ratings,
and there are also ratings at CCC, CC, and C. If a bond drops
below C, it is marked D, for "default." In addition to a rating,
a bond issuer is also assigned an "outlook"positive, stable, or
negative.
All of the colleges now listed as below investment grade are
at the upper end of the junk-bond scale. Of the 17 institutions
now rated in the "junk" category, all but one are BB. Only
Life University is below that, at B.
Analysts of college bonds say that while a drop into "junk
bond" status is not a death knell, it marks the existence of
financial problems so fundamental that recovery would be
arduous.
"It is more typical than not that they don't come back to
investment grade," says Joshua Stern, a higher-education
credit analyst at Standard & Poor's.
"The erosion of resources is difficult to restore."
Mr. Stern wrote a report in November predicting that colleges
and universities might "consolidate in large numbers or close
as they struggle against stagnant levels of financial resources
and substantially higher levels of debt."
In 2002, Standard & Poor's upgraded the bond ratings of
seven colleges and downgraded the ratings of nine, the first
time downgrades have outnumbered upgrades since the mid1990s. From 1990-95, Standard & Poor's upgraded the ratings
of 80 colleges, and downgraded 178. But the trend reversed
from 1996-99, when the ratings agency upgraded 120
institutions and downgraded only 14. Now the pendulum is
swinging back again.
It was predominantly lower-rated colleges that were
downgraded in the last year. "That is pretty much in line with
what we expected," says Mary Peloquin-Dodd, who heads the
higher-education-rating division at Standard & Poor's. "What
we are asking ourselves now is how long the downturn will be
in the sector, and how long it will be before it begins to affect
colleges that appear to be more insulated from financial
concerns."
Moody's had more upgrades of colleges, 29, than downgrades,
18, in 2002. But for private colleges, the number of upgrades
and downgrades were the same, 18. Analysts at Moody's say
the colleges most likely to be downgraded are those losing
students they used to be able to attract.
"When things are going bad, there is sort of a chain reaction,
and it often begins with declining enrollment," says Naomi
Richman, the head of the higher-education analyst group at
Moody's. "Declining enrollment leads to declining tuition
revenue, which leads to operating deficits and poor liquidity.
Colleges can cut, but they can't cut everything, because their
quality will suffer, and then even more students won't come."
Turning Things Around
Before all of the low-rated colleges are written off as goners,
however, consider the case of Dowling College, on New
York's Long Island.
As of June, Moody's had tagged it with the lowest bond rating
of any college in the country, four steps below investment
grade. In September, just as many colleges opened their doors
to another year of red ink, Moody's upgraded Dowling by one
category, and announced that it has a positive outlook on the
college's finances. This, even though Dowling sold $10.9million worth of bonds late last year, adding to the $37million in debt it was already carrying.
Moody's analysts were impressed that the college has a
growing enrollment, and, after years of deficits, it has
balanced its budget for three consecutive years. That came
after a disastrous investment of more than $26-million in the
late 1990s in what was to be an international center for the
study of aviation and transportation. The project failed, and
the center has been turned into a branch campus of Dowling.
How is the college turning itself around?
In late 1999, the college's new president, Albert E. Donor, and
the new chief financial officer and treasurer, Susan E.
Williams, began meeting every Monday at 7 a.m. with six of
the college's trustees to set an agenda for what had to be
accomplished that week. Every step was designed to nurse the
college back to financial health.
"We called all of our vendors, and we said we really need
your help," says Ms. Williams. "'How can we work with you
to maintain ourselves and have it cost less, but still make sure
you get paid.' We talked with them often. So if they didn't get
a check from us, they got a phone call from us, explaining the
situation. Those phone calls have meant a lot."
The college slashed advertising costs for recruiting students,
focusing instead of rebuilding relationships with local high
schools.
It reduced executive salaries across the board, froze hiring,
and beefed up collections on student accounts. Tuition makes
up 86 percent of the college's revenue. No costs were
considered too minor to escape attention, says Ms. Williams.
And, slowly, the situation has improved.
A Flood of Bond Issues
Like Dowling, a number of other colleges in relatively weak
financial condition are going further into debt, reasoning that
they need new science centers, residence halls, recreation
centers, and other facilities sought by students. It's either that,
or close for sure.
D. Scott Gibson, a managing director for Advest Inc., a
Hartford-based investment bank, says the market is being
flooded with bonds from small colleges. Temporarily, at least,
the economy is working in the colleges' favor. Interest rates
are at historic lows.
Even colleges with lower-level bond ratings, such as BBB, are
getting interest rates of around 5.5 percent. Rates at that level
are, in some cases, even lower than the interest rates on AAArated college bonds sold at a time when the economy was
much stronger.
"That's an incredibly low borrowing rate for BBB schools,"
says Mr. Gibson. "Yes, it means more debt, but who's to say
that isn't the best deal going right now?"
But there is a downside, too. Rates for bond insurancewhich
allows a college, or any bond issuer, the chance to buy a
higher credit ratingare up by more than 25 percent in the last
two years, says Mr. Gibson. And underwriters of college bond
issues and the bond-insurance companies are asking for much
more in bond covenantscollateral, stipulations, or other
requirementsthan they used to.
In 1999, the College of New Rochelle, for example, did not
have to offer any covenants, other than a pledge that its debt
would not exceed 15 percent of its annual expenditures.
Now, the discussions begin with colleges offering a mortgage
on the buildings being built.
At Salve Regina University, the bond insurer took a mortgage
on the core of the Rhode Island campus when the college's
$40-million bond issue went to market late last year. At
Western New England College, in Massachusetts, there will
be a mortgage on the residence hall being built with a new
bond issue, meaning bondholders would have preference over
other creditors if the college or the dormitory itself goes bust.
It is just another indicator that investors are looking to protect
themselves, even when buying into colleges, which up to now
have been considered one the safest investments going.
FALL IN VALUE
A growing number of colleges have low bond ratings.
The following institutions have been downgraded since
December 2001 to "below investment grade" ("junk
bond") status, which means that bond-rating agencies believe
they have significant financial problems:
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Clarke College (Iowa)
Eastern Nazarene College (Mass.)
Lasell College (Mass.)
Ohio Dominican U.
Texas Wesleyan U.
U. of Findlay (Ohio)
The following institutions were "below investment grade"
before 2002:
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Bennington College (Vt.)
Daniel Webster College (N.H.)
Dowling College (N.Y.)*
Eckerd College (Fla.)
Franklin Pierce College (N.H.)
Life U. (Ga.)
New England College (N.H.)
Nichols College (Mass.)
Southern California U. of Health Sciences
Touro College (N.Y.)
Tougaloo College (Miss.)
These colleges are currently being reviewed for a
downgrade to "below investment grade":
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Polytechnic U. (N.Y.)
Saint Peter's College (N.J.)
Bond-rating agencies also state whether colleges' financial
outlooks are stable, positive, or negative. The following
colleges are still considered to be above junk-bond status,
but they have the lowest investment-grade rating, and
negative outlooks:
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Bloomfield College (N.J.)
Christian Brothers U. (Tenn.)
College of Santa Fe
Delaware Valley College (Pa.)
Dowling College*
Lewis U. (Ill.)
Regis College (Mass.)
U. of Louisiana at Monroe
* Dowling College is rated "below-investment grade" by
Moody's, and carries an investment-grade rating with a
negative outlook by Standard & Poor's.
SOURCES: Fitch Ratings, Moody's Investors Service, Standard & Poor's
http://chronicle.com
Section: Money & Management
Volume 49, Issue 22, Page A0
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