You asked about the standard or recommended level of reserve funds a town should keep as part of its budget and how the size of the reserve affects a town's bond rating. You also asked if holding an excessive amount of reserve funds would hurt a town's bond rating and what other factors can cause a bond rating change.

The general rule is municipalities should keep between 5% and 10% of their budget in undesignated reserve. Jennifer Lewis, a municipal bond analyst for Moody's Investor Services, said 5% is a minimum informal rule, but she also emphasized that a number of factors are considered in bond ratings and it is not entirely useful to focus on one alone.

Margaret Colligan, Avon finance director, said ratings agencies advised her town to keep its undesignated reserve fund between 5% and 10%. The town finished FY 2000-01 with a 7. 25% reserve balance, she said. Avon is one of only seven Connecticut towns with the highest rating, AAA.

A bond rating is an evaluation of a municipality's credit risk as determined by one of the major credit-rating agencies (Moody's Investor Services, Standard and Poor's Corporation, or Fitch IBCA). The rating tells bond market investors the risk level associated with that particular bond. The highest rating for each of the three major rating agencies, AAA, means municipal bonds issued with that rating are judged to carry the lowest risk of default. AA is considered high investment grade, and A is considered upper medium grade. Below investment grade at the other end of the spectrum, B is considered speculative and C or D is considered high default risk.

Lewis said the level of a town's reserve fund can affect its bond rating, but it is not as important as other factors such as the town's record of managing its finances. But, she added, it is almost impossible for a municipality to attain an AAA without at least 10% of the budget in reserve as one factor in its favor. On the other hand, a town with an established AAA rating will not automatically have its rating reduced if its reserve fund drops below 10%, Lewis said. Colligan said Avon officials are attempting to increase its undesignated fund balance this year to approximately 8%. She also noted that Avon has designated other reserve funds for specific purposes, such as retiree medical benefits and employee compensated absences, and these are also considered in any credit rating review.

Credit rating agencies do not consider any amount of reserve funds to be excessive, said Lewis. She said a large reserve fund enables a town (or any level of government) to handle more easily changing financial or economic situations. "The more you have in reserve the better from the investor's point of view," Lewis said. But, she noted, this must be balanced against the taxpayers' desire to not be taxed more than necessary to adequately fund the town budget. In this sense investors and taxpayers may have opposing views on the need for a reserve fund.

A reserve fund is one indicator of a town's financial flexibility, which is a part of the town's overall finances. Finances are one of the four major factors the Moody's examines when determining a municipal bond rating (for more on this see Attachment 1). The four are:

1. economic factors, including a town's general economic climate plus specifics such as the number of building permits, retail sales, and the financial condition of the town's larger employers and taxpayers;

2. overall municipal debt, including whether the tax base appears capable of supporting the debt service;

3. overall finances, including year-end figures, budget projections, reserve fund, and most importantly, a multi-year trend of financial performance and spending controls; and

4. management and administrative strength and practices, including organization, division of responsibilities, professional qualifications, and authority to perform functions.

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