Citing an excessive amount of existing debt, Fitch Ratings cut the rating for the State of Connecticut’s $956 million bond issuance.  Already the state with the highest level of tax supported debt, Connecticut is issuing these bonds to close a nearly billion dollar budget gap.  Last year the state borrowed over $947 million to cover a  similar budget gap rather than cut spending.  Fitch, apparently, had seen enough and reduced the States rating one level to AA.

“The downgrade reflects the state’s reduced financial flexibility, illustrated by its reliance on sizable debt issuances during the current biennium to close operating gaps in the context of already high liabilities,” Fitch said.

While Connecticut does have the largest amount of outstanding tax supported debt of any of the 50 states at over $13.7 billion, it also boasts being the wealthiest of the 50 states with a per capita personal income of $54,397 in 2009.  I believe much of Fitch’s concern is due to how the state is using the funds it borrows.  Spending for long term capital improvements that benefit Connecticut citizens is one thing.  At least then you have a hard asset to show for it.  What Connecticut is doing, borrowing to finance a budget deficit, is akin to running up your credit card debt to finance a lavish lifestyle.  Frankly, it is unsustainable.

One has to wonder if this is the first of many such downgrades to come as we witness the consequences internationally (Think PIIGS – Portugal, Ireland, Italy, Greece and Spain) of excessive borrowing to support an unsustainable spending pace.

Yesterday, the Motley Fool website ran an interesting article by Nick Kapur titled “Why do we still listen to the ratings agencies“.  The general premise of the article is that the ratings agencies are either unable or unwilling to provide an accurate assessment of a company’s financial strength.  The author goes on to contemplate what role the ratings agencies played in the recent financial meltdown and how much responsibility we should assign them.

“The line here between ignorance and dutiful compliance is thin and not meaningful. Though many have alleged that the ratings agencies were on the take outright, it doesn’t really matter if they were or weren’t. Essentially, the ratings agencies were either crooked or they were stupid. Either way, they’re guilty.”

The article raises an interesting question of what role should a Moody’s or S&P rating play in an investors analysis?  Should they still be trusted, or have they lost all investor confidence?  Finally, is there an opportunity for a new player to emerge as a truly unbiased opinion, and what would that new player have to do to earn the respect of the investing community?

I believe there is an opportunity, but the road to respect will be a long one.  Thorough, independent analysis will always be worth much more than a 3rd party report from a vendor whose motivations may be cloudy at best.

Bloomberg ran an article (see link here) this week about how the state of Florida has temporarily suspended the issuance of Build America Bonds due to a potential glitch in the refunding mechanism.  For those that aren’t as fmailiar with the Build America Bonds, or BABs as they are known, they are a product of the ARRA Stimulus legislation and represent the fastest growing segment of the $2.8 trillion municipal debt market.  The BABs are unique in that they are issued as taxable bonds with taxable equivalent yields, yet the issuing locality receives a refund from the IRS equal to 35% of the interest costs.  This, effectively, makes the cost to the issuer on par with tax free options.

Florida, however, has some concerns about how that 35% subsidy will be paid and has put its $255 million upcoming issuance on hold.  In a recent call with the Internal Revenue Service, the IRS reiterated that any subsidy due to the locality will be reduced by any amount that the issuer owes the federal government for other programs, including Medicare.  This is not a new provision of the BABs and has been a condition since their inception.  However, many of the localities are just now catching on to the fact that they may not get the full subsidy they have been expecting.

This becomes especially relevant as Congress seeks to pass the Healthcare Reform that could dramatically increase an issuers payments to the federal government for Medicare and similar type programs.  Should an issuer not be able to make its Medicare payments, the IRS will still get “theirs” through the BAB subsidy, leaving the locality in a death spiral of interest obligations.

According to the article, the largest issuer of BABs, California, is aware of the IRS claw-back provision and is continue to utilize BABs as a viable funding source.  It will be very interesting to see how many other states join Florida in taking a wait and see attitude.

The worst may not be over yet for the US Municipal Bond market.  That’s according to a recent report from the ratings agency Moody’s Investors Service.  The report shows that in 2009, the agency downgraded 279 state and local government tax-backed bonds.  That is up 244% from 2008 when Moody’s downgraded only 81 such entities.  Overall, the ratings fell for 300 revenue debt issuers, up from 133 in 2008.

While the struggles that state and local governments are facing to balance their budgets is nothing new, we are beginning to see the hardship take a toll on their credit ratings.  Those lower credit ratings will make it much more difficult and costly to issue bonds, exacerbating the problems they are facing.

I recently came across this bleak outlook for the US Municipal Bond Market written by Frederick J. Sheehan (see link below).  While this is just one man’s opinion, it’s enough to give a bond investor at least a few sleepless nights.  Some of the historical precedents he points out, especially those from the Depression Era, are chilling.

The Coming Collapse of the Municipal Bond Market (PDF)

It should come as no surprise that analyzing and quantifying “risk” are the name of the game in this economy.  The risk profile for Municipal Bonds is no exception.  Unfortunately, there may be some validity to the concept that Municipal Bonds carry more risk than anyone had anticipated.

In a further sign of the distress apparent in the bonds markets, the yield curve for US Treasuries moved to its steepest level in recorded history yesterday.  The spread between 2-year and 10-year notes breached 275 basis points.  The sharp increase in yields seems to be a result of concerns over the levels of debt the US government is incurring and how they will fund the spending.  According to a CNBC article,

With $2 trillion or more in issuance seen coming to market this year alone, some dealers were looking for a sharp readjustment in bond rates—which effectively reflect the cost to government of financing its borrowing.

The treasury did experience good demand for yesterday’s auction of $35 billion of 5-year notes.  However, strong demand for shorter term notes indicates a lack of demand for longer term issuance’s.  These are the ones that typically finance many of the municipal projects that provides the local services we, as taxpayers, demand.  In addition, the increase in longer term rates has a profound effect on mortgage rates, driving them up further.  This could serve to slow the improvements in the housing market, a sector which the US badly needs to improve in order to pull it from this recession.

While the debt markets may not be the most exciting thing to watch, they are extremely important to health and well being of our economy.

The US Department of Education is changing its position on whether Stimulus Funds can, and should be used to fund new school construction.  In April, the DOE had indicated that new construction was an allowable use for the funds.  Last week, however, the DOE changed their position in an update to their previous guidance.  Now, the department is strongly discouraging the use of Stimulus Funds for new construction.  They have even gone as far as to indicate that anyone who does use the funds for new construction will be penalized in consideration for the “Race to the Top” money.  

Apparently, the funding of new school construction continues to be a hotly debated topic.  Keep in mind that $14-$16 billion of funds for new construction were stricken from the final Stimulus Bill.  There’s clearly a need, but no one is quite sure how to fund that need.