The charter school sector is inherently risky and volatile, relative to other public finance sectors, as reflected in our ratings distribution, and charter nonrenewal or revocations can affect credit quality swiftly. However, despite these intrinsic risks, the majority--82%--of S&P Global Ratings' ratings in the sector carried stable outlooks as of Dec. 31, 2019. While the sector is facing increasing political support for stricter charter laws or oversight in some states, federal government support for school choice remains strong, per-pupil funding is generally stable to growing, and demand for charter schools continues to grow. From a financing standpoint, charter schools' opportunities and options have expanded and interest rates remain low.

Our rated universe increasingly reflects more established charter schools, which generally have completed several successful charter renewals, maintain steady academics, and experience less credit volatility than newer schools. While there are inherent credit risks that can affect schools throughout the year, such as failure to meet authorizer standards, charter nonrenewal due to factors such as academics, or enrollment shortfalls, we believe the sector's outlook for 2020 will continue being stable due to continued demand and growing per-pupil funding levels. However, should charter law and policy changes of significant impact occur in states where we hold a large number of ratings, or some of the broader risks (such as a slowing national economy or recession) transpire during this calendar year, charter schools could face more credit stress.

For charter schools, the most dominant risk which has permeated the sector is the impact of the 2018 elections, which were felt in 2019 state legislative sessions nationally. While charter school supporters continued to achieve some legislative gains, such as increasing facilities support and funding and protecting autonomy, they have also faced increasingly hostile climates in several states, such as California, as a result of the elections. While we anticipate that education reform--and specifically, the operating environment for charter schools--will be a central debate in the 2020 elections which will likely have future ramifications on the sector, we believe the majority of charter schools operating today will maintain stability overall this year.

Overview Of Sector Ratings

As of Dec. 31, 2019, S&P Global Ratings had 287 public ratings on charter schools in 26 states. In 2019, California replaced Texas as having the largest number of publicly rated charter school credits (35, up from 33 at the end of 2018). Texas is close behind with 33, and Utah has 31 (see chart 2). Colorado and Michigan have 28 rated credits each. Certain states such as California and Texas have large charter school networks with multiple schools supporting a single rating. The charts below reflects the number of obligated groups issuing rated debt, and not the number of schools or networks. Chart 2 depicts ratings for the states in which we have five or more ratings.

Chart 1

Our charter school ratings range from 'A-' to 'D'. IDEA Public Schools Inc., Texas' debt holds an underlying rating of 'A-', an upgrade achieved in 2019 based on our view of IDEA's national brand recognition, track record of growth, maintenance of very high academic results and solid operating margins, as well as its position as the largest charter school network in the U.S. based on enrollment. We have only one issuer rated below 'B-' as of Dec. 31, 2019. On Nov. 1, 2019, we lowered our rating on Plymouth Educational Center Charter School's series 2005 bonds to 'D' following a missed bond principal payment as permitted under its forbearance agreement.

Approximately 54% of our ratings are either 'BBB-' (32%) or 'BB+' (22%, see chart 1), and while 82% of the ratings currently carry a stable outlook, negative outlooks (35, or 12%) outpace positive ones (13, or 5%, see chart 3) highlighting the inherent pressures facing individual schools within the sector.

Chart 2

Chart 3

As of Dec. 31, 2019, charter schools with negative outlooks remain at 12%, comparable to this time last year. However, as we look at median data over time, the rated sector continues to stabilize and we believe metrics will remain steady overall despite some risks on the horizon. We anticipate that a meaningful change in these metrics could happen beyond 2020 to the extent there are notable changes in charter law across a multitude of states; an economic shift occurs and strains state budgets affecting per-pupil funding; or other risks in operations and finances such as rising pension costs, natural disasters, school security and safety, or increased unionization affecting a critical number of rated charter schools.

During 2019, we affirmed 82% of the charter school ratings overall (see chart 4) and rating performance resulted in a lower number of rating changes (29 total upgrades and downgrades compared with 41 in 2018, see chart 5), reflecting an overall stabilization of ratings compared with previous years.

Chart 4

Chart 5

In 2019, we lowered 21 ratings and raised only 8 (see chart 5); this compares with lowering 26 in 2018 and raising 15. We also assigned 17 new public ratings, compared to only six in 2018, as depicted in table 1 below.

Table 1

While the majority of rated issuers, which continue to mature, are stable, the charter school sector is susceptible to some unexpected credit profile changes, which could relate to failure to meet authorizer standards, charter nonrenewal due to academics, or enrollment shortfalls, that can occur at any time. Because of this, charter school ratings tend to be more volatile than ratings in some other sectors of U.S. public finance. During the past year, we continued to see examples of these credit risks particular to the charter school sector. In 2019, S&P Global Ratings had seven multiple-notch rating actions in the sector (see table 2) unique to an issuer; this compares with nine in 2018 and six in 2017, the year in which we published revised criteria. Six of the 2019 multiple-notch rating actions were downgrades and only one was an upgrade; two of the downgrades related to the same issuer (Plymouth Educational Center Charter School).

Table 2

There were many reasons for the multiple-notch downgrades in 2019. These included contingent liquidity risk, deteriorating credit fundamentals caused by declining enrollment, legal compliance issues, and weakening financial performance and covenant violations. None of our rated charter schools closed in 2019 (although some saw campuses close), comparable with 2018. However, our rated universe did see an increase in payment defaults (failure to make payment of principal and interest as scheduled, per S&P Global Ratings' definition) from zero in 2018 to three in 2019: STRIDE Academy, ASPIRA of Florida, and Plymouth Educational Center Charter School. The downgrades and ultimate payment defaults were caused by a variety of reasons, including prolonged enrollment pressures leading to financial issues, weak academics, management turnover, charter contract issues, amongst others. While these types of events aren't uncommon in the sector, we believe these three examples represent individual situations and are not indicative of any sector-wide trends. The one multiple-notch upgrade, for Rocky Mountain Academy of Evergreen, was due to growth in enrollment and finances.

As 2020 progresses and we continue to review our charter school ratings, we believe our expectation that the majority of ratings will not change will continue to bear out. Furthermore, our rated issuers will continue to reflect more mature and established charter schools with less volatility.

What We Are Watching For In 2020

Changing political environment is front and center

Critical decisions affecting charter schools -- from authorization to funding mechanisms--are determined at the state level, and political changes can have material impacts. Midterm election changes in 2018 caused a loss of charter advocates in many states, and during this past year we have seen increasing support for less-favorable charter laws, including proposals for charter school moratoriums and caps or limitations on expansion, which could have material implications for operating environments in many states. As 2019 state legislative sessions concluded, some states with the largest number of charter schools passed legislation demonstrating a changing political and policy environment. While federal support for school choice continues, we expect national scrutiny will increase as charter schools versus traditional public schools is a key election topic in 2020.

Much attention has been placed on California, which experienced the most comprehensive overhaul to its charter school laws since they were first passed over 25 years ago. We think Assembly Bill 1505, signed into law by the governor, will make it more difficult for new or expanding charter schools to get approval from authorizers, although for high-performing charter schools it could mean longer renewal terms or a more streamlined application process. However, this remains to be seen for our rated universe given this bill is new and its full effects are yet unknown. While charter school supporters continued to achieve some legislative wins (discussed later in this report), they also faced changing political climates in several states as a result of the elections. Other examples include Illinois, where the State Charter School Commission (the state's appellate body) was eliminated as was the ability for new charter school applicants to appeal school district denials. In Maine, the legislature voted to make the current cap of 10 charter schools permanent and included district-authorized charter schools within the cap. Prior to this change, the cap was set to expire in 2022 and only included state-authorized schools.

While legislation enacted during 2019 that enforced caps or placed greater challenges around charter school petitions will likely limit charter school expansion in certain geographic areas, for the most part, we don't expect related material credit issues for our rated universe, as many are established schools with long tenures and steady finances. Limitations on virtual (cyber) schools affect only a small percentage of charter schools, and the vast majority of our rated universe are brick-and mortal schools. Our "Charter School Briefs," introduced in 2019, provide a snapshot of the operating environment for charter schools on a state-by-state basis, which we expect will continue to provide a valuable view of charter school issues by state in 2020 (see "S&P Global Ratings Introduces Charter School Briefs," Dec. 9, 2019).

Competition and demographics

While demand for charter schools continues to grow, and many areas have seen traditional public school districts' enrollment decline at the expense of charter school enrollment growth, changing demographics continue to ratchet up competition for students in some states. In many cases, the charter schools are authorized by the school district, and relationships between the charter school and the authorizer vary greatly, with some supportive and some severely restrictive or antagonistic, given the inherent conflict of interest for school districts that compete for the same students and the related per-pupil revenue. Enrollment in public elementary and secondary schools is projected to increase very modestly during the next few years, but the disparity in growth rates between states and counties is striking. As the map below indicates, growth rate projections expect the minor population (as defined by ages 0 to 24) to rise in the South and West, but to decline materially in the Northeast and Midwest, over the next five years. In some areas with very limited growth expectations, the struggle for students is more palpable.

Chart 6

In our opinion, while differences at the state level determine much of the statutory framework and financial metrics of a charter school, these differences can be exacerbated in areas facing weakening school-age demographics. For example, Pennsylvania charter schools tend to see more adversarial school district authorizers with heightened conflicts of interest due to diminishing student age demographics. Allegheny and Delaware Counties have projected five-year school age population declines of 3.8% and 1.8%, respectively, while Philadelphia is stable at 0.7% growth. We also believe a lack of clarity in the state law regarding the renewal process further hinders the relationship and charter standing in Pennsylvania. Even though the charter environment is friendlier in Colorado, in our opinion, where additional property tax mill levies are shared with charter schools, population rates, such as Jefferson's and Douglas' projected declines of 4.8% and 2.4%, could be concerning for charter schools operating in these areas. Because enrollment is a key credit factor in our credit analysis, any material changes can affect financial operations and impede credit quality. In our view, weakening demographics will be a key credit risk for schools in certain areas.

Table 3

Disruption caused by event risk

While we have discussed the numerous credit risks inherent in the sector, such as failure to meet authorizer standards or charter nonrenewal or revocation, there are a growing number of additional event risks that have emerged. At the end of 2018, teachers at Acero Charter School Inc. (BB+/Stable) in Chicago went on strike in the first teacher walkout at a charter school in the country. This strike lasted four days and resulted in higher teacher pay and smaller class sizes, which we projected would motivate further unionization efforts during 2019. For Acero, management had already budgeted for certain pay increases, with a teacher pay scale that matched that of Chicago Public Schools, and was operating with smaller class sizes at certain campuses; as a result, the organization was able to absorb the impact of the final negotiations, with no change to the current rating. However, Acero's enrollment has been declining in recent years, and while the four-year collective bargaining agreement provides greater expense clarity over a longer timeframe than the previous two-year contracts, we believe future operating flexibility could be limited with stipulated required pay increases for teaching staff should enrollment continue to decline at a similar pace and funding projections remain uncertain.

Only about 11% of charter schools nationwide are unionized, unionization efforts in charter schools have increased during the past few years, and we expect this activity will likely continue in 2020 given the successes achieved by charter school teachers so far. While Chicago dominated strike activity in 2019, it was not the only city home to frustrated teachers. Several other areas experienced walkouts or protests by educators for better pay, benefits and more, with issues varying. Los Angeles (in which about 33% of charter schools are unionized) also saw a major strike in early 2019, when the United Teachers Los Angeles union demanded a cap on charter schools as part of contract negotiations. In an interesting turn of events, teachers from several charter schools joined forces with the school district teachers in Los Angeles against the L.A. Unified School District, the nation's second-largest school system. Ultimately, the strike concluded with a deal including caps on class sizes, the hiring of full-time nurses for every school, as well as a librarian for every middle and high school in the district by the fall of 2020. For charter schools, a resolution was passed by the elected school board to ask the state to "establish a charter school cap" (the state currently allows for 100 new charter schools to open per annum).

We expect 2020 will see an increasing focus on teacher wages, benefits, and working conditions, especially in regions where teacher shortages are creating pressures. At the same time, we note that in certain areas, we are seeing increasing funding efforts to better support teacher salaries, which can offset a need for unionization.

Table 4

In addition to disruption caused by strikes, environmental, social and governance (ESG) attributes continue to come to the forefront of credit discussions with charter schools. On March 28, 2019, we published "When U.S. Public Finance Ratings Change, ESG Factors Are Often The Reason" and highlighted that 54% of the ESG-related charter school rating actions taken in the prior two years were driven by social factors, while the other 46% were driven by governance factors. Unsurprisingly, enrollment levels, as discussed in the section above, were key factors for charter schools, due to demographic issues and increasing competition for students with public school districts. Governance-related risks associated with a charter school's ability to maintain its chartered status, state funding levels, and academic performance to meet state and authorizer standards are also key credit factors in the sector. Additionally, "headline risk" continues to increase across the charter school sector, with several incidents in 2019 related to management and governance issues that we believe charter schools will continue to face. As risks to charter schools continue to arise from less-traditional areas--such as governance scandals, school shootings, further unionization or strikes, or cybersecurity issues --we believe management teams will need to address increasing questions regarding transparency and sufficient and timely disclosure.

Chart 7

Growing pension and OPEB costs stress budgets

Although most charter schools are not unionized and are exempt from many state and district regulations, many do participate in their respective state's pension plan. As the burden of unfunded pension and other postemployment benefit liabilities increases, the cost is passed on to participating school districts and charter schools, which can pressure operating budgets. The lower-for-longer economic forecast coupled with the living-for-longer demographic trend has made some state pension plans credit-drivers. Compounding this, many state pension plans prudently continue to lower their assumed asset return assumption in order to reduce market risk, and accept that this leads to higher costs. However, pension and OPEB challenges are not uniform across the states. While some states have very large current and future cost obligations, others are at or close to being fully funded with limited risk of escalation, so the effect on credit from this obligation can vary greatly. On Oct. 7, 2019, S&P Global Ratings published a "guidance" document, "Assessing U.S. Public Finance Pension And Other Postemployment Obligations For GO Debt, Local Government GO Ratings, And State Ratings." This document lays out our views of risk associated with various pension metrics, including assumptions in the measurement of liability and methods used to fund that liability over time. The map below indicates fiscal 2018 pension funding levels.

Chart 8

For charter schools in states with low funded ratios, schools are seeing increasing required pension and other post retirement contributions which can stress budgets as they grow yearly. Per our charter school criteria, we view low pension plan funding ratios and a failure to cash fund actuarially determined contributions or statutorily required contributions in full, negatively. Our assessment includes a forward-looking view of changes in assets and liabilities, funded ratios, and funding discipline. We expect to see possible rising pension and retirement obligation costs for schools in certain states, which could further soften EBIDA margins, debt service coverage, and result in fiscally constraining pension and OPEB contribution burdens as a percentage of annual operating expenses. We evaluate each individual school's financial flexibility and ability to manage any additional cost burden on a case-by-case basis, and in some instances, rising pensions costs do impact a school's overall credit profile and rating. We expect this risk will remain an important credit factor given climbing pension and OPEB contributions nationally.

Economy at peak of the cycle

Following the Great Recession in 2008, most states cut student funding significantly. While state legislatures have gradually increased this funding, many are still funding below pre-recession levels. Charter schools have benefited from a strong economy recently and this has translated into higher per-pupil funding in most states. While expectations vary by state and county, per-pupil funding levels for charter schools are generally expected to be stable to growing in fiscal 2020, and in some states, projections grow into 2021. In states where capital funding per student is available, these levels have also been steady to growing. As we look forward to fiscal 2021, should state revenue forecasts weaken due to an economic downturn or slower growth, finances at rated entities could be impaired given how heavily reliant charter schools are on state funding.

As the new decade begins, U.S. state credit is generally strong. Possibly nearing the end of the longest economic expansion in modern history, states are delicately balancing service delivery costs, building reserves, and mitigating future risks like climate change. However, S&P Global Ratings' economists think that this economic cycle is either in--or fast-approaching--its latter stages. According to our recent economic forecasts, expected spending under the recently enacted Bipartisan Budget Act of 2019, favorable financial conditions (thanks to interest-rate cuts by the Federal Reserve), and an apparent calming of the trade seas, at least for now, support slightly above-trend GDP growth next year. S&P Global Economics now sees 2020 real GDP growth at 1.9%, up from 1.7% in our September forecast--and near our 1.8% estimate of the potential growth rate. We've also lowered our estimate of the risk of recession in the next 12 months to 25%-30%, from 30%-35% (although it remains near the top of the new range). This compares to 15%-20% at this same time last year. (For more on our 2020 economic projections, see "Fewer Signs Of Scrooge-ing Up U.S. Growth In The New Year," published Dec. 4, 2019.) The impacts from slower economic growth could vary greatly by state, but for some it could mean reductions in per-pupil funding. While we have ratings in 26 states, and many of them have seen material increases in per-pupil funding post-recession, this is not the case across all states. In Michigan, the governor had originally vetoed an increase of roughly $240 per student for charter schools as part of budget deliberations, but did not veto a similar increase for traditional public schools. Ultimately, while the veto was reversed as part of a long-awaited budget compromise, this highlights one example of how charter school funding is differentiated from and often lags traditional public school funding.

Funding equality creates opportunity

Even though the charter school sector faced increasing hostility in certain states, there was also positive news in 2019, as attempts to restrict charter school growth were defeated in Illinois, Nevada, New Mexico, North Carolina, and Wisconsin. At the same time, many states also made improvements to funding levels and equalization. Colorado increased equalization funding for state-authorized charter schools to $7 million next year from $5.5 million this year; and Florida required schools districts to share tax revenues generated from school district-voted discretionary millage levies with charter schools based on each charter school's proportionate share of the district's total unweighted FTE enrollment. Florida also provided $158.2 million to its charter school capital outlay fund. While, overall, Illinois' charter school environment worsened, the state did appropriate $34 million in capital funding to several charter schools in Chicago as part of the state's capital bill. Ohio allocated $30 million per year in supplemental state aid for high-performing charter schools, allowing schools to receive an additional $1,750 per pupil for economically disadvantaged students and $1,000 per pupil for other students, and Tennessee doubled the state's previous contribution to the Charter School Facilities Fund, bringing the fund to $12 million for the coming grant year. Numerous other states increased grants and facilities funding for charter schools and parity funding conversations and legislation continue across the nation in charter states.

Charter schools and networks continue to expand

As the charter school sector matures, we continue to see successful, high performing charter schools expanding as their schools reach capacity and waitlists grow. At the same time, we hold ratings on numerous networks that grow by several schools per annum, with expectations for this type of growth to continue.

Table 5

While the majority of the nation's charter schools--about two-thirds--are freestanding schools that operate independently from any management organization, the remaining third utilize some sort of management organization to support their operations, ranging from day-to-day operations to back office support. Philanthropic foundations and federal policymakers have been promoting the growth of charter management organizations (CMO, not-for-profits) and education management organizations (EMOs, for-profits) to run schools, and some of the benefits proponents of management organizations cite include economies of scale, centralized governance and management oversight, sharing of best practices, and ease of replication and growth. Both types of organizations are networks of schools managed by a central leadership team that provides shared academic, human resource, back-office, operational, and financial services and holds the charter for the network of schools. As more stringent authorization requirements, and increasing real estate and labor costs heighten the barriers to entry, management organizations tend to have greater financial resources to replicate or start a new school. We expect this growth trend to continue, albeit not evenly across states. From a rating perspective, we don't distinguish between management organizations and independently run schools, or CMOs and EMOs, but assess the relevant credit factors pursuant to our criteria.

Table 6

Access to capital

Overall, charter school issuance volume has grown each year since 2011, outside of a one-year decline during 2018. Market activity in 2019 increased modestly due to very low interest rates and strong demand for high yield municipal debt. With these factors expected to continue, we believe the sector will likely face stable-to-increased capital market activity in 2020. While bond financing can still provide significantly lower rates than many other forms of capital financing for charter school, there continue to be increasing financing options for charter schools beyond rated debt, and investors continue to purchase charter school transactions on an unrated basis.

Charter school bond issuance continues to be heavily concentrated in a handful of states, with Arizona, California, Colorado, and Texas ranking in the top both by number of transactions and volume. The presence of state credit enhancement programs like the Texas Permanent School Fund (AAA/Stable), the State of Arizona Public School Credit Enhancement Program (AA-/Stable), the State of Colorado Moral Obligation Program (A+/Stable), and Utah's Moral Obligation Program (AA/Stable) continues to aid charter schools that qualify in these states. Creditworthy schools in Colorado, Utah, and Texas (with underlying credit profiles of 'BBB-' or higher) as well as eligible, academically high-achieving schools in Arizona--all states with significant charter school activity--can access their individual state's credit enhancement program, resulting in higher enhanced ratings ranging from categories 'A' to 'AAA', thereby significantly reducing interest costs. Notably, in 2019, Idaho joined this club and passed a bill to create a charter school facilities program fund, which will help lower interest rates on bonds for school facilities, although no schools have yet issued bonds under this program.

Additionally, in 2019, the charter school sector saw its first first-ever pooled charter school loan program, Equitable School Revolving Fund, Del.'s (ESRF) series 2019A and B bonds (see full analysis). S&P Global Ratings assigned its 'A' rating to this loan program, under our municipal pool rating methodology, broadening the financing options available to charter schools at a lower cost of capital. Of the 11 charter schools included in the loan program, nine hold public ratings from S&P Global Ratings, with the highest underlying rating at 'BBB'. Despite the highest rating in the pool being a 'BBB', the pool received a higher rating because the entire transaction is making overcollateralization available to bondholders. Regardless of whether one particular charter school has a payment default, the value of that additional collateral can have real upward rating potential--in this case to an 'A' rating. We expect to see more structures like this, as Equitable Facilities Fund (EFF, the sole member of ESRF) is currently in process with its second tranche, providing additional opportunities for charter schools. We note that eight of the 17 new public ratings we assigned in 2019 were ratings for schools participating in EFF's loan program.