The ratings agency Standard & Poor’s recently downgraded the state of New Jersey once again. This downgrade is far more perilous to the municipal bond market than average investors realize. As a former municipal bond trader myself, here’s my take on what the downgrade of New Jersey means for investors and residents of the state.
What S&P Said in the Downgrade of New Jersey
The ratings agency stated that the structural problems in the state’s pension are expected to worsen. Voters recently approved a record 23 cent increase in the gasoline tax, taking it from one of the lowest in the country to one of the highest.
As anyone who has ever spent time in Jersey knows, taxes there are already some of the highest in the country. When I worked as a bond trader, the state toll road authority was being used as a piggy bank for the rest of the state because tax revenue sources are mostly tapped out. The Turnpike Authority kept raising tolls and adding as much debt as they could to bolster the horrific financial condition of New Jersey in other places. The state officials basically did anything they possibly could do to kick the can down the road until Christie is out of office.
Now voters added the last tax available, which is the new gas tax. However, they restricted the funds solely for transportation projects. That means none of this new money can go directly to the $135.7 billion unfunded pension liability.
On top of this, Christie and the Democratic legislature agreed to cut taxes for New Jersey residents. While that’s a noble goal, ratings agencies were already warning of a revenue shortfall this year in income tax receipts. Cutting another source of desperately needed revenue for the state is going to render the pension contribution goals completely impossible.
S&P is saying that New Jersey is totally screwed. They moved the rating for the State General Obligation bonds to A- from its current A rating. That might sound good until you learn that the other ratings above that are AAA, AA+, AA, AA-, A+, and A.
Why Most New Jersey Debt is Slowly Moving to Junk Territory
I would not know this if I wasn’t a former muni bond trader, but the vast majority of New Jersey debt is actually not pure general obligation. It’s something called appropriation debt, which means investors rely on the state legislature to set aside money for bond payments every year. In New Jersey, it’s really hard to get new bonds passed with the full faith and credit of the state, so they use a workaround that’s less legally secure and investors have let them get away with it.
Instead, the legislature issues bonds in its name with a promise to pay. For every $1 of true NJ GO debt, there is probably $7-$10 of appropriation debt. New Jersey appropriation bonds are the primary issuer in the state.
This appropriation debt is notched one rating lower than the general obligation debt. The reason is that unlike most GO bonds, New Jersey actually has no legal obligation to pay with appropriation debt. The market would destroy them if they failed to appropriate money, which is why they keep paying on the debt even though they legally do not have to. However, in a scenario of extreme fiscal stress, the state could decide not to pay.
Because of this less secure structure, appropriation bonds in New Jersey are rated one category below the GO bonds. Hence, now that the state of New Jersey is A-, the appropriation bonds will be BBB+.
The Current Credit Profile of the Average New Jersey Bond Fund Will Be Affected by This Decision
I looked at three major New Jersey Bond Funds at T. Rowe Price, Fidelity, and Vanguard. All of them had over 50% of their holdings in the A rated category. With this change in credit quality, that credit quality percentage will start to tumble and a huge percent of these funds will eventually move to the BBB category. Keep in mind that anything below BBB is considered a junk bond.
Moody’s is currently at the A- equivalent on New Jersey appropriation bonds. They came out with a note recently stating that their outlook is negative after the tax changes in the state. Eventually Moody’s will catch up to S&P. After all S&P’s outlook is still negative on the state even after their downgrade.
If A Couple More Downgrades Happen, Get Ready for Mass Selling
If a few more downgrades happen, many New Jersey bond funds could be forced to sell a plurality of their holdings. After all, appropriation debt is the primary holding in most of these state specific funds.
The appropriation debt is now rated at BBB+ with S&P. If only 2 more downgrades happen, most of New Jersey’s debt will sit at BBB-. One more notch down after that and many mutual funds will become forced sellers of Jersey paper.
On top of these problems, many of these bonds have call options and coupons of 5%-5.5%. If interest rates keep rising, then suddenly their duration can double or even triple because of bond math. That means losses would accelerate at precisely the wrong time. In this extreme scenario, you could see a run on New Jersey mutual bond funds.
New Jersey’s Pension Situation is One Stock Market Correction Away from a Disaster
This is probably really weird but I have the state of New Jersey’s monthly investment reports saved on my bookmarks page. I visit the page several times a week to see if any new information has come out about the pension. They are in deep, deep trouble as the assumed rate of return has about a 1% chance of being met over the next 10 years, as I’ve documented in other posts.
Jersey is already paying billions and billions of dollars out of the pension fund to meet obligations. Say we had a 20% correction. The state would then have to withdraw a huge amount of money to pay benefits at exactly the wrong time when you would want to stay invested in the markets. When this happens, it will permanently doom the pension. It’s only a matter of time.
I stand by my prediction that the worst funded of the state pension funds, the New Jersey Teachers’ Pension and Annuity Fund, will be bankrupt within 8 years. I think the situation will continue to unravel despite the state raiding money out of the better funded police and fire fund to put off disaster until Mr. Christie is playing golf somewhere in Florida with Jerry Jones.
Unlike Illinois, New Jersey Can Actually Default and It’s Totally Legal
Illinois is currently in worse shape than New Jersey technically. Illinois is even making late payments on bills and barely operating with the semblance of a budget. The difference is that there’s money to go after to cover pensions, as Mayor Rahm Emmanuel’s new record breaking property tax increase in Chicago shows.
In New Jersey absolutely every revenue source is tapped out. Eventually the state will have a choice between paying bondholders of appropriation debt and paying pension holders. Which group do you think the politicians there will choose? States cannot legally declare bankruptcy, which is true. However, that restriction does not apply to General Obligation Appropriation debt, which is what New Jersey uses for the majority of its financing needs.
So when interest rates rise, interest costs continue to mount, and mass selling from state specific mutual funds due to prospectus guidelines makes market access for New Jersey virtually impossible, the state will have no choice but to impair creditors. Pension benefits will likely be targeted too.
There are dark days ahead for New Jersey’s finances. With the recent policy decisions after this latest election, I believe we’re past the point of no return. DO NOT invest in New Jersey municipal bonds or bond funds. The state tax exemption in my opinion is not worth it. Buy a national municipal bond with more diversification instead.