OREANDA-NEWS. S&P Global Ratings lowered its rating on Detroit Public Schools (DPS), Mich.'s series 2011 bonds secured by state aid to 'BB' from 'BBB', and its rating on DPS' series 2012 bonds secured by state aid to 'BB-' from 'BBB-'. The first - and second-lien ratings are differentiated by one notch given their respective pledge levels. The ratings remain on CreditWatch with negative implications, where they were placed March 10, 2016.

"The downgrade is based on the lack of a formal plan regarding bondholder repayment terms following the recent restructuring of the district, and the resultant elimination of a pledged revenue stream at the end of the state's fiscal year," said S&P Global Ratings credit analyst Jane Ridley. Although the intent is to take out the existing debt at full value, in our view, as October approaches and ushers in the new fiscal year, it creates greater uncertainty as to whether bondholders will receive full and timely payment on their bonds.

The CreditWatch placement reflects the possibility that we could lower the rating further if the redemption, refunding, or defeasance is not moving to conclusion in a timely manner. 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.

Under legislation recently passed by the Michigan legislature, on July 1, 2016, the district was divided in two, creating a new district to be called Detroit Public Schools Community District that will take over all operations (the New Co) and continue to receive state school aid, while DPS (the Old Co) survives solely to collect tax millage and service debt outstanding. The Old Co will no longer be eligible to receive state school aid.

The pledge on these bonds is state school aid as well as the district's limited tax general obligation (GO) pledge, and the rating is based on the state aid pledge. The separation of the Old Co and New Co leaves the Old Co as the obligor for the bonds. State aid can only flow to school districts that have students, and the Old Co has no students. As a result, the only remaining fundable pledge backing the bonds when the state starts its next fiscal year on Oct. 1 will be the limited tax GO pledge. S&P Global Ratings does not rate bonds secured by DPS' GO pledge.

Because state aid will no longer support the bonds effective Oct. 1, 2016, in our view the situation must be resolved by then or bondholders will lose a critical revenue stream, which would result in a significant reduction in value.

The CreditWatch on the bonds reflects our view that the complexity of the situation, the looming requirement to redeem, defease, or refund the bonds, and the numerous parties involved--including the split district and Michigan--result in a more than 50% chance we will lower the rating over the next two months. If the situation is not resolved in a timely manner and the risk to bondholders increases, we will lower our rating to reflect our opinion of the deterioration in the credit quality of the bonds. If we view the redemption as providing less than the original promise, we would likely consider this a distressed exchange, which we rate 'D'. In a redemption, refunding, or defeasance without a loss of value, we would withdraw the rating. Given the timing and circumstances, there is no upward potential for the rating at this time.