California Bonds Downgraded Again: How Low Can They Go?

 |  Includes: AKP, BFZ
by: Kurt Brouwer

MarketWatch reports that another rating service, Fitch Ratings, has knocked California bonds down a notch, so that speculative or junk bond status is now a bit closer [emphasis added]:

Fitch Ratings downgraded the California’s general obligation credit rating on Thursday to A-minus from A, based on the magnitude of the state’s financial challenges and persistent weakening economy. The state’s finances will continue to be strained through fiscal year 2010 and beyond regardless of any likely outcome to the current budget impasse, Fitch analysts said in a report. The outstanding bonds are also on Rating Watch Negative, reflecting short-term concerns about the state’s ability to solve its liquidity crisis…

If you are wondering what Fitch’s scale is, here is an excerpt from a lengthy report on their website:

AAA: Highest credit quality.

‘AAA’ ratings denote the lowest expectation of default risk. They are assigned only in cases of exceptionally strong capacity for payment of financial commitments. This capacity is highly unlikely to be adversely affected by foreseeable events.

AA: Very high credit quality.

‘AA’ ratings denote expectations of very low default risk. They indicate very strong capacity for payment of financial commitments. This capacity is not significantly vulnerable to foreseeable events.

A: High credit quality.

‘A’ ratings denote expectations of low default risk. The capacity for payment of financial commitments is considered strong. This capacity may, nevertheless, be more vulnerable to adverse business or economic conditions than is the case for higher ratings.

California G.O. bonds are now at A- so that is the lowest level in the A rating with BBB next on the list.

BBB: Good credit quality.

‘BBB’ ratings indicate that expectations of default risk are currently low. The capacity for payment of financial commitments is considered adequate but adverse business or economic conditions are more likely to impair this capacity.

BBB is the last of the ‘investment grade’ ratings. I suppose they could go to BBB- and still be clinging to investment grade, but that would be a stretch. After BBB there are various speculative ratings. When bonds go below investment grade, they join the ranks of high yield or junk bonds.

As the ratings go lower, the corollary is that the state must pay higher and higher interest rates to attract borrowers. Also, if the rating falls below BBB, then many investors, particularly high quality municipal bond funds, may have to dump California bonds because they would no longer be investment grade. Yikes.

These are the Fitch speculative ratings. Let’s hope California bonds never get there.

BB: Speculative.

‘BB’ ratings indicate an elevated vulnerability to default risk, particularly in the event of adverse changes in business or economic conditions over time; however, business or financial flexibility exists which supports the servicing of financial commitments.

B: Highly speculative.

‘B’ ratings indicate that material default risk is present, but a limited margin of safety remains. Financial commitments are currently being met; however, capacity for continued payment is vulnerable to deterioration in the business and economic environment…

The modifiers “+” or “-” may be appended to a rating to denote relative status within major rating categories. Such suffixes
are not added to the ‘AAA’ Long-Term IDR
[KB: Issuer Default Rating] category, or to Long-Term IDR categories below ‘B’.

Via: Jack H. Scaff III