The Risk of Buying Bonds Issued Where You Live: The New Jersey Case

by: SL Advisors

By Simon Lack

On Tuesday, Standard & Poor’s downgraded New Jersey’s credit rating one notch, from AA to AA-, illustrating why residents of the Garden State should be the least likely buyers of their state’s debt.

New Jersey is not alone in having mismanaged its fiscal affairs for many years. California and Illinois are both tough competitors for the mantle of Fiscal Incompetence Champion. S&P cited New Jersey’s public pension obligation and the fact that the assets necessary to meet future pensions are $54 billion less than required. Incoming Gov. Chris Christie’s first budget omitted a required $3 billion pension contribution because, as the governor frequently reminds us, we don’t have the money. In fact, last year federal regulators accused the state of securities fraud for falsely claiming its pension fund was fully funded when in fact it is not. The SEC settled with New Jersey, the state neither admitting nor denying the charge. While the suit didn’t mention any state officials by name, I don’t know why anyone representing the state in its securities dealings would see fit to misrepresent its finances. In the private sector a CFO behaving similarly might face jail.

The New Jersey resident owning his own state’s municipal bonds has not only seen his holdings deemed slightly more risky by the rating agencies, but also faces the prospect of paying to make the situation right through higher state and property taxes. It’s a doubling up of risk, and hardly prudent for an investor in municipal bonds who is presumably seeking modest income with capital preservation. The shielding of interest income from state income tax that New Jersey residents enjoy on their own bonds seems scant reward for such concentrated risk. Personally, having watched the sad management of our state’s finances for many years by both parties I wouldn’t own NJ bonds even if I didn’t live here. But as a general matter of portfolio diversification, investors should avoid bonds issued too close to home.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.