This is a series of articles to look at the investing opportunities in municipal bonds in today's economy. Part 2 will look at the recent downgrade of the State of New Jersey by Moody's and what to look for when making an investment in a municipal bond.
My last article discussed the looming budget crises faced by the State of New Jersey. Three days later Moody's Investor Service dropped the credit rating outlook to negative from stable.
As an investor you should be familiar with all of these terms and what they say about your potential investment. Most public investment have a rating from either Standard & Poor's or Moody's Investors Service or both. These two companies will examine an issuer of debt securities (bonds) for a fee and give their opinion of the "creditworthiness" of the issuer. Creditworthiness means the ability to pay interest and principal on time. This is the most important determination before you invest in bonds. Can the borrower (issuer) pay the interest on the loan and repay the note at maturity?
The rating agencies (Moody's and S & P) are profit making companies and collect a sizable fee to give an opinion about the financial wherewithal of the issuer (I will discuss the value of this rating and the recent performance of these agencies in a future column). This opinion is expressed by assigning a grade expressed in letters. The highest grade is triple A expressed as Aaa by Moody's and AAA by S&P. The ratings decline by single letters, i.e. Aa, A, Baa, Ba, B, etc. Triple A investments should be gilt edged with no doubt about the financial strength of the borrower. The ratings on bond investments will range from highly safe (AAA) to highly speculative (C). The lower the rating the less chance of repayment and the greater chance of default. In addition to the ratings, the agencies will express an opinion in the form of a comment such as "stable" or "negative," which gives an indication of future expectations and future ratings.
In the case of New Jersey, the rating agencies are looking at declining revenue collections and increased expenses. As an investor in municipal bonds you need to know the key facts to look for to determine the financial strength of the issuer. Just like individuals, cities, states and municipalities manage their finances differently. Some entities are better or more fiscally responsible than others and that should be reflected by a higher rating from Moody's or S&P. Also some issues are insured which will pay interest and principal when due should the issuer default and not pay.
The bigger the municipality that issues the bonds the greater should be the security for the investor. The reason is simple: states have more resources than cities and cities have more resources than small towns. While the counter argument can be advanced that the bigger municipalities have bigger problems, there are more avenues open to larger issuers than smaller. If the State of New Jersey has a shortfall they can draw from the entire state to correct the shortfall. If, for instance, Trenton, the state capital, has a major industry relocate to Jersey City, it is good for Jersey City but bad for Trenton. The impact on the state is net neutral; the state doesn't care where the business is located because the tax collections will be the same.
Another important piece of the puzzle is to examine the financial statements of the issuer. In the last thirty years states and municipalities have been getting better about publishing their financial information. This information is available, sometimes on a delayed basis, but a firm that specializes in fixed income will be able to provide it. The municipal bond industry recognizes that they need to do a better job in having the financial information disseminated quicker and on a regular time table. Financials are generally available but not every investment firm knows how to access them.
Your investment professional needs to be conversant with this information both to understand the investment and to provide it to the investor.
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