The Risk Is Becoming Reality - Credit Downgrades Already Affecting Some Muni Bonds
By Ric Edelman
One year ago, I warned you that investors who are turning to municipal bonds as a safe way to invest would eventually discover that they’ve made a huge mistake.
Bondholders of some New Jersey municipalities have already learned the lesson. Bonds are subject to two primary risks: rising interest rates and declining credit quality. When either occurs, bond values fall — and although the former is not an immediate threat (at least for as long as interest rates remain low), some state and local governments are in bad financial condition. If a bond rating company downgrades an issuer’s creditworthiness, that issuer’s bonds would drop suddenly, immediately — and potentially dramatically. For instance, the value of a AAA-rated bond would fall 8% if its issuer’s rating fell to AA.
And that’s exactly what has happened in New Jersey. In the fourth quarter of 2009, Moody’s cut the ratings on almost $600 million in General Obligation bonds that were issued by 14 of the state’s municipalities. That means the value of those bonds has gone down.
The downgrade occurred because of the state’s shaky finances. New Jersey faces a budget deficit estimated at $8 billion beginning July 1, and the state may slash spending by as much as 25% — meaning municipalities are expecting to receive much less money from the state — just as declining property values have reduced real estate taxes (despite the fact that New Jersey has some of the highest property taxes in the country). All this makes Moody’s wonder whether the municipalities will be able to pay interest and principal as promised.
New Jersey, of course, isn’t the only state facing bond downgrades. Illinois’ credit rating has also been downgraded recently, along with several towns in New York, among others.
So if you own municipal bonds because you think that they are safe, think again. The market value of these bonds is not necessarily as secure as you might think.
From the March 2010 Inside Personal Finance.