As outlook sours on K-12 credits, some schools will fare better

School districts face a post-pandemic financial predicament as federal and state funds dwindle while declining birthrates and increased competition from charter schools present enrollment challenges.

Moody’s Ratings, which issued a negative outlook for K-12 credits late last year, now reports state laws and local governance will allow some districts to better adapt.

As a result, investors and analysts will more closely examine K-12 issuers, hoping to find those with prudent management that will allow them to weather what one Brookings Institution report called a “perfect storm of financial chaos.”

A ‘challenging budget cycle’
During and after the COVID-19 pandemic, districts benefited from a windfall of federal dollars, including $190 billion in aid through the Elementary and Secondary School Emergency Relief Fund, which will end in fiscal year 2026.

Many districts used the funds to retain employees or hire staff amid pandemic-related attribution, often raising compensation, according to the Moody’s report on school credit which gave the sector a negative outlook. Those recurring costs will be difficult to unwind as districts pass budgets without federal support. Additionally, staff will want contracts to account for inflation, the agency predicted.

Population trends may also cause stress for schools.

In places with declining enrollment, districts are losing state dollars, which are traditionally appropriated per student attending, according to the Moody’s report. For some districts, the problem is declining birthrates. Others are losing students to charter and private schools, especially in places where recent state legislation made it easier for families to choose alternatives to public schools.

Even increased enrollment is a “double edged sword,” said Gregory Sobel, a senior analyst at Moody’s who covers K-12 school districts. More students can mean more state funds and better local support, he said, but accommodating them also comes with capital investments, and the costs of building facilities have inflated greatly in recent years.

In Texas, which has one of the fastest growing student populations in the country, “we are seeing school districts undertake increasingly large capital plans, many of which are multi-phase, to keep pace with rapid growth, aging facilities, and evolving educational needs,” said Stephanie Henning, an executive director in Wells Fargo’s Texas public finance practice. The districts are navigating the projects amid a “challenging budget cycle, working hard to maintain fiscal stability amid shifting legislative dynamics, funding uncertainties, and rising operational costs.”

In California, where enrollment is projected to greatly decrease in coming decades, “we’re expecting credit to gradually decline,” said Travis McGahey, vice president of Payden & Rygel, a California-based investment firm. There is still high demand for school bonds and spreads are tight, he said, but the coming cuts and costs are unavoidable. 

At the Los Angeles Unified School District, the state’s largest, for example, the average facility was built around 1970, said McGahey. The district can only put off the cost of renovations for so long, he said.

Differing outcomes
But the impact will be different for distinct districts.

“Districts with stronger budget management and revenue-raising flexibility, as well as growing state support, will be able to weather reduced federal funding,” the agency said in a report released last week. “Reduced state funding, limitations on districts’ ability to generate additional local revenue, and intrastate school choice efforts will exacerbate governance risks.”

Their framework is based on four factors: institutional structure, transparency and disclosure, policy credibility and effectiveness, and budget management.

But often districts’ success in those metrics is determined by what state they happen to be in, not their actual management, said Moody’s Sobel. A district’s ability to raise revenue or compete with charters, for example, is almost entirely dependent on the state laws they operate under, he said.

Numerous districts garnered stronger and weaker scores in every state, despite the medians, said Anik Hoque, an analyst in Moody’s public finance group.

Investors hoping to buy K-12 bonds in this environment will have to be more judicious than before, said Jeff MacDonald, head of fixed income strategies at Fiduciary Trust International

His firm is looking closely at how districts used the pandemic-era federal funds. If schools spent them on one-time costs, like new facilities, that suggests prudent management and could be good for the district’s long-term financial health, he said. But, if a district used that temporary money to take on recurring costs, like employees, it could create a real burden now that the federal support has ended, he said.

Investors are also looking at state-level data, MacDonald said. Somewhere like Texas, with fast-growing enrollment and a state-funded guarantor, “has a lot going for it.” Many northeastern states, meanwhile, are losing population and thus require closer examination, he said.

Investors should also look closely at what local competition an issuer has and how much choice local parents have in pursuing it, he said, as charter schools can be a bigger drain on enrollment than population trends.

The risks could fall hardest on schools in low-income areas. The distribution formula for recent federal funds prioritized “districts with the greatest needs — a group that includes some of the nation’s largest districts,” Moody’s noted in its downgrade report. 

That functioned as a sort of equalizer, with districts that long struggled with revenue suddenly receiving an inflow of federal cash, said Eleni Schirmer, a research associate at UCLA.

The loss of those funds and a return to debt financing will reverse that dynamic, she said. Districts in low-income areas will garner more scrutiny from ratings agencies and investors, leading to higher interest rates on their debt. Over time, that will further widen the financial gap between them and wealthy districts that can borrow at cheaper rates, said Schirmer, who has published research on K-12 borrowing.

‘Political hot potato’
Investors will also have to be increasingly cautious of a “politicization of school finance” as districts contend with new challenges, said MacDonald. One cautionary tale is the budget saga at Toms River Regional School District in New Jersey, he said.

The district has been losing state funding since a formula change in 2018, and, as put in Fiduciary Trust’s note to investors on the subject, their school board was “faced with two choices: layoffs and larger classes, or higher taxes.”

The district chose to threaten to file for bankruptcy, forcing a state board to impose a budget that both cuts funding and hikes local taxes. S&P Global Ratings then downgraded the district.

“This was never a credit risk,” said the note from Fiduciary Trust. Rather, it was “about Toms River SD not wanting to be the “bad guy” even though the higher tax solution was the way to balance the budget. They simply forced the state to pull the trigger with the threat of a Chapter 9 filing.”

In MacDonald’s view, the saga is a sign of times to come. Local boards and state policymakers both have electoral concerns, and they may supersede financial prudence, he said. His firm is still “an active investor in this part of the market, we consider it to be high quality,” but he said financial stress will require them to scrutinize issuers more closely.

“It could get nasty,” he said. “With all these pressures, it becomes a bit of a political hot potato.”