Stateline Story

Bond Rating Drop Another of States' Fiscal Woes

State bond ratings have taken a beating over the past two years, costing state governments hundreds of millions of dollars in higher interest payments and adding to long-term budget problems.

California is the most recent state to take a hit. Its bond rating was downgraded last week by Standard & Poor's, one of three major bond rating agencies. California is now the lowest rated state.

California Treasurer Phil Angelides said the downgrade could cost the state $1 billion over the next 30 years, because California will have to pay higher rates on its bonds to attract investors. The same budget-busting logic applies to other states facing lower ratings.

"Interest rates of course reflect risk. A lower bond rating means there is a higher credit risk, so consequently, interest costs tend to be higher. As a result, state borrowing costs will increase," said Robert Kurtter, senior vice president for state ratings at Moody's Investors Service, a bond rating agency.

The California legislature completed action late Tuesday night on a budget that pushes much of the state's $38 billion deficit into the future through heavy borrowing.

Moody's has lowered the bond ratings of nine states since July 2001 -- California, Connecticut, Illinois, Minnesota, New Jersey, North Carolina, Oregon, Tennessee and Wisconsin. Thirteen states have negative outlooks, according to Moody's.

Standard & Poor's has lowered ratings for five states over the past two years -- California, Colorado, Kentucky, New Jersey and Wisconsin. The agency said 11 states have negative outlooks.

"There have been a bunch of downgrades, which is pretty unusual. We haven't seen that since the recession of the early 1990s," Kurtter said.

Louisiana is the only state to have its bond rating upgraded during this period, although its current rating is still low relative to other states.

The reason for the recent spate of downgrades and warnings is that many states are on shaky fiscal ground due to the wobbly economy. As a result, they are finding it difficult to generate enough tax revenue to pay for state programs.

The choice facing states: cut program or raise taxes. Bond analysts generally don't care which course of action states follow. What they don't like to see is excessive borrowing or gimmicky accounting to paper-over serious problems.

"What [bond raters] have tried to stress, to somewhat depoliticize the process, is that they are looking for what they call structural balance. ...Simply put, that means roughly having your revenues match your expenditures with a reasonable margin of error included. ...It's a simple concept that is not easy to achieve in practice," said John Hallacy, managing director of municipal research at Merrill Lynch.

Despite the great fanfare that usually accompanies state bond rating downgrades, Hallacy said state governments, even California, generally remain good investment options, provided the investor can tolerate a little more risk.

"This is a case where we have a state that is at the investment grade edge. ...So it may not be suitable for everyone, but for a portfolio that can tolerate a little more risk it's an opportunity to buy...and avail themselves of some outsize returns," Hallacy said.

The reason state bonds are generally considered solid investment options is because states have the ability to raise money and cut spending in ways that private corporations, and even local governments, can only dream of.

"States are sovereign, they have large tax bases, they are not like corporations, they can't go out of business and they have largely good management," said Moody's Kurtter.

In fact, Kurtter said he doesn't know of any state that has ever nose-dived into junk bond territory, despite recent warnings that California may be flirting with such an event.

"I don't recall a time, and I don't know that in our recordkeeping, at least the recordkeeping that goes back to 1973, and I don't know of any earlier time where we've actually had a state rating that was junk bond status," he said.