Darrell Preston

Bloomberg News

Michigan’s plan to bail out Detroit Public Schools is putting debt backed by state aid at risk of falling into default if the bonds aren’t refinanced by mid-October.

Ratings have been slashed twice by S&P Global Ratings since late June on the district’s debt by a total of six levels, relegating them to junk status.

“Detroit Public Schools and the Michigan Department of Treasury are in the process of refinancing the bonds with a goal to have this completed prior to Oct. 1, 2016,” district spokeswoman Chrystal Wilson said Wednesday. “We are diligently working on this task.”

Michigan’s restructuring of the district’s finances diverts state payments on about $370 million of bonds sold in 2011 and 2012 to a new, debt-free Detroit school district that doesn’t have any responsibility for the old debt.

The state still lacks a plan to refinance the bonds, and S&P said that without one, it would likely consider the DPS debt a distressed exchange that would merit being labeled as a default.

“S&P was in its rights to downgrade,” Tamara Lowin, director of research at Belle Haven Investments. The firm oversees $5.3 billion of municipal debt and doesn’t own any district debt. “There was debt outstanding for which the revenue stream has disappeared. That is in itself alarming.”

Under a $617 million rescue plan approved in June by state lawmakers, the Detroit district was split in two. The new, debt-free Detroit Public Schools Community District is to open next month with about 46,000 students in 97 schools, while the debt of the former Detroit Public Schools is to be paid off with a combination of state aid and collections from the district’s 18-mill non-homestead levy, which is collected on businesses and second homes.

The restructuring approved by state lawmakers and Gov. Rick Snyder was designed to the give Detroit’s schools, reeling from the same population decline that bankrupted the city, a “clean slate,” Snyder said when he signed the bill June 21.

Moody’s Investors Service, in a report issued a week later, said the restructuring was “credit positive” for bondholders “given that the district was teetering on bankruptcy and was reportedly unable to make payroll absent an immediate infusion of revenue.”

In the weeks leading up to approval of the rescue plan, DPS Emergency Manager Steven Rhodes had warned that the district was in danger of running out of cash by June 30 without state aid.

Under the state restructuring plan, the existing district would continue to pay off the district’s old debt, including about $2.2 billion of bonds and pension liabilities from property taxes. The state will provide about $467 million to help repay the old debt.

The Michigan Finance Authority, which issued the debt cut by S&P for the district, is putting together a plan to refinance the debt by Oct. 20, Danelle Gittus, spokeswoman for State Treasurer Nick Khouri, told Bloomberg.

“The downgrade of the bonds does not impact the District’s or the Michigan Finance Authority’s ability to refinance the bonds before October 20th,” Gittus said a statement emailed to The News. “The finance plan is being developed and per the notice to investors, they will receive no less than par at the time of refunding.”

Since the legislation was signed, S&P cut the 2011 bonds to BB from A and the 2012 bonds to BB- from A-. Moody’s doesn’t rate the bonds S&P cut, but has a Caa1 rating with a negative outlook on the district, seventh in the junk category.

“It’s a surprise that it was in the A category, then it’s BB,” said Bill Bonawitz, director of municipal research at PNC Capital Advisors, which oversees $6.5 billion in municipal bonds. “How do you go from being an A rated bond to a BB rated bond in a matter of five weeks? That’s a huge difference.”

S&P said it made its assessment based “on the lack of a formal plan regarding bondholder repayment terms” and the elimination of one of the pledged revenue streams in the fiscal year that begins Oct. 1.

The restructuring needs to be in place before Oct. 20, when state aid moves to the new district, leaving the bonds rated with S&P with just the property-tax pledge. Lack of specific details on the plan to refinance the two bond series creates uncertainty for bondholders, S&P said, raising the risk of default.

“If they don’t get it refinanced, the loss of the revenue stream is going to seriously erode bondholder value,” Jane Ridley, an S&P analyst, said.

S&P, the only firm that rates the 2011 and 2012 bonds, said in an Aug. 3 report that separating the state-aid payments from the bonds creates a more than 50 percent chance the debt could be cut again in the next two months.

It warned that it could use its D, or default category, if repayment is less than originally promised.

“As October approaches and ushers in the new fiscal year, it creates greater uncertainty as to whether bondholders will receive full and timely payment,” S&P wrote. “If the actions taken through this process provide bondholders with anything less than the full promise of the original bonds, it is likely to be considered a distressed exchange and therefore a default under our criteria.”

It appears the district will end up refinancing its debt, said Lowin of Belle Haven Investments.

Detroit News Staff Writer Shawn D. Lewis contributed to this report.