The Keystone State is the latest to experience a recent credit action from S&P. Illinois, Kentucky, and Puerto Rico havealso seen their ratings lowered due to budgetary challenges and pension deficits. Pennsylvania’s already difficult credit situation worsened, as Standard & Poor’s Ratings Services discontinued ratings on Pennsylvania’s credit enhancement program for school districts. State aid intercept programs operate as a safeguard in the event that a local school is not able to meet its debt payments. This announcement, which was made on April 26th, 2016, comes just months after S&P withdrew ratings on the Pennsylvania state aid intercept program in December 2015. In April 2016, S&P withdrew ratings on PA school districts that were solely based on the state’s intercept program. According to the rating agency, “The withdrawal is due to the current impasse on the fiscal 2016 budget, which has extended over 5 months past the start of the fiscal year… The duration of the budget impasse… indicates a lack of commitment to the state aid intercept program.” With budget problems lingering in the state, S&P felt its action was appropriate due to “…our expectation of the unlikelihood of the rating being reinstated.” As a result, ratings on bonds issued by PA school districts are now based on the soundness of each individual district.
Implications for Fixed Income Portfolios
States that have experienced these actions often have several common characteristics. The first, and most noticeable, is financial troubles. This can come from failure to formulate an annual budget, as in the case of Pennsylvania. It can also come from large pension deficits, as in the case of Illinois and Kentucky. A clear example is language from the S&P report downgrading Kentucky’s credit rating to ‘A’ from ‘A+’. “The downgrade reflects our view of Kentucky’s substantially underfunded pension liabilities that are the result of chronic underfunding and that we view as placing long-term pressures on the state’s finances.” (Emphasis added) Banks with investment policy constraints for non-rated investments may be required to sell their holdings. Fortunately, most school districts in PA carry an underlying rating. However, this isn’t the case for every state. For example, the majority of KY school bonds are solely reliant on the enhancement program for their rating, with little transparency of their financials. Unrated securities may be subject to impairment testing, given that a major credit event has taken place, and can also lead to lower liquidity if the bank looks to sell its position. Diversification is a best practice that can help minimize portfolio risk. The old saying “don’t put all your eggs in one basket” applies perfectly here. While banks across the country tend to be comfortable owning bonds issued by their home state, do not be afraid to venture beyond your borders. Looking at issuers in different states can provide opportunities to find strong credit quality and higher relative value that might not exist at home.
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