U.S. colleges have been scrambling to refinance often heavy debt loads that have left some uncomfortably exposed to the vagaries of the credit markets.
In a report early this month, bond rater Moody's Investors Service said the outlook for the higher-education sector was negative. In part, analysts cited colleges' reliance on "volatile" debt markets. Last year, the ratings agency downgraded or changed the ratings outlook on 29 colleges.
A key area of concern: most schools' reliance on variable-rate demand bonds, whose payments are tied to prevailing interest rates. The bonds often bear lower rates than plain-vanilla, fixed-rate debt. That is why they are so popular among colleges, which have used them since the 1980s.
Moody's said the 300 private colleges it rates have sold $25 billion in variable-rate debt, or about 39% of their borrowing outstanding. Almost three-quarters of the colleges sell variable-rate debt. Among the schools that have used the instruments are Harvard and Princeton universities, which recently replaced variable-rate debt with fixed-income borrowing while retaining their top AAA bond ratings.
Variable-rate debt has a big catch. Although the bonds have maturities as long as 30 years, investors can demand repayment in full with little notice. Colleges typically secured a guarantee from a bank to be a buyer of last resort to protect them. But the terms of that credit typically call on schools to repay the banks in three to five years.
Complicating matters, many colleges entered into arrangements that let them, in effect, pay fixed rates on their variable-rate bonds. They achieved that by entering into interest-rate swaps with big banks. In many cases, colleges would face hefty fees if they ended those swap arrangements.
Analysts at Moody's and Standard & Poor's said most colleges should be able to weather the debt storm through budget cuts and fund raising. But Mary Peloquin-Dodd, a managing director at Standard & Poor's, said a few could face "severe circumstances" if they can't find financing to repay a bank quickly.
In November, Moody's downgraded the debt of Simmons College, a women's school in Boston, to Baa1 from A3, citing risks associated with variable-rate debt. Standard & Poor's made a similar downgrade.
Simmons took on $100 million in variable-rate debt over the past decade for various campus projects. In a recent report, Moody's said the school has only $52 million in unrestricted funds that it could use to repay that debt. Were investors to demand early payment, it could result "in rapid credit deterioration for the college," Moody's wrote.
Simmons is finalizing a deal to sell about $39 million of fixed-rate debt to replace a batch of variable-rate bonds recently trading at distressed levels -- with interest rates of almost 10%.
Helen Drinan, Simmons's president, said it's unlikely that investors would demand repayment on the rest of the bonds, which have long-term bank backing. But she said that, over time, Simmons plans to replace those bonds with fixed-rate debt, as well. "Without a doubt, no institution wants to face an acceleration of its debt, which can be crushing," she said.
To shore up its finances, the college cut about 5% from its budget, now about $100 million, and froze hiring.
In September, investors redeemed $235 million in variable-rate debt issued by the University of Pittsburgh because of concern about the credit-worthiness of the bank that provided a backstop for the bonds. The University of Pittsburgh, which has a high investment-grade credit rating, was able to restructure its bonds so that its own financial resources now back the bonds.
Write to John Hechinger at john.hechinger@wsj.com
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