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Downgrading of New Jersey's Debt by S&P

Standard & Poor’s lowered its rating on a whole range of the New Jersey's debt. The action highlights how much opportunity and risk exist in the muni market, where yields are high and the fear of default is, too.

Despite the best efforts of New Jersey Governor Chris Christie, Standard & Poor’s lowered its rating Wednesday on a whole range of the state’s debt. The action highlights just how much opportunity and risk exist in the muni market, where yields are high and the fear of default is, too.

The state’s $2.6 billion in general obligation bonds were downgraded one level to AA- from AA. S&P lowered its rating on various agency appropriation debts to A+ from AA-. And it lowered its rating on South Jersey Port Co. debt, which the state has a “moral obligation” to back, to A- from A. New Jersey has about $27.8 billion in outstanding appropriation-backed debt and $2.5 billion in moral obligation debt.

Back in September, Christie proposed cutbacks in state pension benefits and a new health care plan that would require state workers to share more of the cost.

Christie said the state legislature has “dallied” and called him “chicken little. "Well, the sky started to fall in today, because now when we need to borrow money to keep government going, to do long-term capital projects, it's now going to cost us more to borrow because we've been downgraded, because they in the Legislature have acted for the special interests and not for the public interests,” Christie said.

The troubles in New Jersey — which had to scale back a bond offering last month — are just the latest sign of trouble in the municipal bond market, where the slow economy, high debt level and soaring fixed costs put pressure on state and local government. In the case of New Jersey, S&P analyst Jeff Panger said in an interview on Wednesday that high pension costs, above-average debt, and post employment benefit costs were factors in the downgrade. A new set of S&P criteria, announced in January, also led to the ratings action. “The downgrade is a reflection of New Jersey fiscal situation and the long-term financial liabilities the state is facing,” Panger said.

The problems in the muni market — which effect a broad range of locales from New Jersey to New York, Pennsylvania, Rhode Island, Illinois and California — present investors with both opportunity and risk.

The fiscal troubles at the state and local level translate into generous returns for investors, who are benefiting from muni bond yields that quite high by historic standards. The ratio of the yield on the 10-year Treasury bond to the 10-year muni bond is about 1.54, compared to a average historic ratio of 1.04, according to Hugh Johnson, chairman and chief investment officer of Hugh Johnson Advisers in Albany, New York.

“It is very hard for states not to have a fiscal problem,” Johnson said Wednesday in an interview. Given the level of fixed spending obligations and declining revenue, keeping budgets in the black is very tough even for public officials that are trying to tackle the problem.

Johnson thinks the market will avoid widespread defaults. But he said there will be problems, and some issuers will default. The question for yield-hungry investors is where will those defaults be, and how widespread will they be?

Public sector unions and taxpayers will absorb the vast majority of the pressures on issuers of general obligation bonds and appropriation bonds for essential services such as water. “Most of the problems are likely to occur in revenue bonds for special projects, such as the next municipal stadium or incinerator,” Johnson says.

What can investors do to protect themselves? “The number one thing to keep in mind is that ratings still matter,” he says. And investors should consider the size of the issuer. Small municipalities are more likely to run into trouble than large ones.

The good news, he says, is that there’s no question many muni bonds “are very attractively priced.”

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