A divergence of demand for large, well-known higher education credits from smaller, lower-rated ones is creating both risks and opportunities for investors in the sector in a post-COVID world.
Competition in the higher education market is hurting the smaller credits as they deal with enrollment challenges due to changing demographics, as well as an increase in the use of remote and hybrid education models that they are not as well equipped to accommodate.
The higher education sector has taken a harder hit than others fromthe pandemic, but leading institutions with substantial endowments should be able to weather any reduction in enrollment and in-person instruction. Smaller, regional and localized institutions, however, face a more difficult path to a post-COVID recovery.
Undergraduate enrollment is down over 6% since fall 2019, but four-year colleges have fared better and selective institutions have even seen increases, according to a Fitch report.
Institutions with less competitive student demand characteristics or a highly regional or local student base bear a disproportionate share of demographic pressures.
“Everything I see rated A-plus and above is thriving,” said Pat Luby, a municipal strategist at CreditSights during a virtual webinar. “These institutions have huge endowments … These are worldwide brands. They get to choose their enrollments. They have unlimited pricing power. People from all over the world want to go to American top-tier universities.”
Flagship state schools tend to get good support from legislatures and tend to attract students, Luby said.
But colleges rated BBB and lower face more pressures, since they
didn't have the financial flexibility to proactively react to the pandemic, possibly having cut expenses pre-pandemic or didn’t have the fundraising capabilities and endowment to fall back on.
Luby said earlier this year investors should be cautious and selective in buying lower-rated — A-minus or below — higher education bonds, since they frequently have little liquidity, have deteriorated credit quality over the previous decade, and have negative demographics.
In the pastyear, excellent endowment investment returns and federal COVID relief bills offered budgetary assistance, but higher education faces greater post-pandemic uncertainty than other sectors.
Nevertheless, investors may find value at lower rating levels in higher education, with spreads still wider than they were pre-pandemic.
Given national trends, the upside is restricted, but these credits frequently feature stabilizers that provide a lengthy runway on the downside and minimize default risk, according to Luby. Long-term bondholders can benefit from greater coupons while reducing their risk of default by carefully selecting their bonds.
Conversely, AA-rated and AAA-rated higher education credits are among the strongest in the municipal market. These credits are known for having global names, large endowments, rising demand, and exceptional pricing power. According to Luby, elite universities have increased their enrollment and resources, pushing out lesser-known names.
“You've got to be very careful when you're investing in higher ed right now. There are some schools that are going to do better going forward, and there are other schools, where what was problematic has now become more severe challenges and they're at risk,” he said.
Scott Douglass, who has served as chief financial officer at several major universities, including North Carolina State University and the University of Delaware, said problems in higher education go beyond the pandemic — the sector had been struggling for years — and demographics play a role. Many of the schools are operating on thin margins and lack reserves, a situation exacerbated by the pandemic.
Additionally, the pandemic caused a drop in international students — a key revenue raiser for universities — attending U.S. colleges last school year.
Figures from the Institute of International Education and the U.S. State Department found the number dropped 15% to 914,095 students in the 2020-2021 school year, the greatest reduction in more than seven decades.
It will take some time to reach the pre-pandemic levels.
And while enrollment is down, Barclay strategists said in a report results are better than those of a pre-vaccine/pre-stimulus survey that predicted a 15% enrollment decline and $45 billion revenue loss by fall 2020.
In another clear trend over the previous decade or two, the sector had been gradually switching to online learning. Total enrollment declined by almost a million students between 2012 and 2019, but the number of students enrolled only in distance education climbed by over 800,000, the Barclays report found.
The pandemic spurred a rapid and near-total transition to online instruction in spring 2020, hastening teacher and student acceptance of a long-running trend.
“The paradox is that in some ways, those [larger] institutions have done quite well during the pandemic because they could switch to virtual teaching and things of that nature because they have the resources and technology,” Douglass said.
Hybrid online and in-person delivery modes are expected to persist.
Institutions with strong online programs may be able to expand their geographic reach in the future, and universities that want to increase enrollment by expanding their online offerings will encounter an increasingly competitive environment.
Changes in enrollment can also affect college and university ratings. “As enrollment declines, so do the ratings,” according to Ted Molin, vice president and senior municipal credit analyst with Wilmington Trust. “But it's enrollment driving ratings rather than ratings driving enrollment.”
“Institutions with limited financial reserves have borne the bulk of recent negative rating actions and remain the most vulnerable to credit deterioration, consolidation and closure," said Fitch Senior Director Emily Wadhwani in a report.
“Market performance buoying endowment valuations will only serve to widen that gap further in coming years,” she said.
For example, the University of Akron in Ohio has been experiencing significant enrollment declines that predate the pandemic. In 2010, Fitch rated the university AA-minus and the agency reaffirmed that rating as recently as 2016. But in 2018, the university was downgraded to A-plus and to A in 2021.
Jessica Wood, a senior director for charter schools and higher education at S&P Global Ratings, said most of the ratings changes for colleges and universities during the pandemic were not solely driven by the pandemic, since the metrics to rate them use a three-year weighted average.
“Some of the downgrades we saw at the end of 2020 were because those schools had already been facing challenges, and then, the pressures of the pandemic exacerbated those challenges,” Wood said.
There’s differentiation that's growing between the winners and losers in higher education, Molin said.
"The stronger credits and stronger universities, ones that have solid market position or some sort of niche specialty, seem to be getting stronger,” Molin said. “Those that don't have any particular strengths or focus seem to be getting weaker over time in terms of demand, which is really the big driver in the sector.”
