Explainer: Why NJ’s Bond Rating Was Downgraded, and Why It Matters

Mark J. Magyar | May 20, 2014 | Budget, Explainer
Higher interest rates resulting from shaky credit status means it will cost more for the state to borrow money

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Last week, Moody’s Bond Services followed Standard and Poor’s and Fitch Ratings Inc. in dropping New Jersey’s bond rating from AA to A-status, joining Illinois and California in the bottom tier among the 50 states.

It marked the sixth time – twice by each of the three major credit rating agencies – that New Jersey’s debt has been downgraded since Gov. Chris Christie took office, a dubious distinction matched only by the six downgrades suffered under former Democratic Gov. Jim McGreevey between 2001 and 2004.

Why does it matter? New Jersey’s bond rating is used by investment banking firms to determine how high an interest rate the state will have to pay investors both on new bonds, such as bonds the School Development Agency used to finance new public school construction projects last year, and on refinanced bonds that are reissued to take advantage of lower interest rates or to extend the number of years before the bonds must be paid off.

The lower the bond rating, the higher the interest rate the state has to pay. This is important because New Jersey doesn’t just ranks third in the country in outstanding state debt, at $41.4 billion — behind only California and New York, and ahead of more populous states like Texas, Pennsylvania and Florida.

Even more crucial, New Jersey has been borrowing so heavily for the Highway Transportation Trust Fund, which pays for highway, bridge and mass-transit construction projects, that it will run out of money a year early, forcing the state to come up with a new five-year, $8 billion plan to start sometime in Fiscal Year 2016 that is expected to rely heavily on borrowing.

What do ratings say about state’s finances? The bond ratings issued by the three major bond ratings agencies provide the most reliable assessment by a neutral analyst of a state’s long-term fiscal stability, including its future pension, retiree health benefit and debt service obligations.

The three bond agencies issue reports each year following the introduction of the new state budget. They analyze the reliability of its revenue forecasts, the sustainability of its revenue base, and the adequacy of its reserves to cope with revenue shortfalls or unforeseen spending needs. The bond agencies also issue mid-year reports when fiscal conditions change.

The rating agencies also rate each state’s credit outlook. All three agencies lowered New Jersey’s credit outlook from “stable” to “negative” months before lowering the state’s bond rating to single-A status. Credit outlook ratings generally remain in place for 12 to 18 months before being reevaluated.

Fitch Ratings, for example, lowered New Jersey’s credit outlook to “negative” in late March before dropping the state’s credit rating on May 3, and Moody’s issued a warning on New Jersey’s latest $807 million budget shortfall on April 29 before cutting the state’s bond rating two weeks later.

Why did they lower New Jersey’s bond rating? The major rating agencies based their credit outlooks and their bond ratings on similar criteria, which is why the issuance of a lowered bond rating by one firm is usually followed by similar downgrades by the other two within a matter of months.

The major factors the bond rating agencies laid out in lowering New Jersey’s bond rating were:

  • The continuing growth of the state’s unfunded pension liability, which is expected to hit $54.1 billion by Fiscal Year 2018 in the final year of the seven-year ramp-up to full actuarially required funding, and $23 billion in future retiree health benefit costs that are the obligation of the state government.
  • While the 2011 law cutting cost-of-living payments to retirees and requiring public employees to pay more toward their pensions and health care provided a long-term plan to stabilize the system, the rating agencies note that the seven-year phase-in of pension payments will actually increase the unfunded pension liability each year until after FY 2018).

  • Slower-than-projected revenue growth, including the Christie administration’s failure to hit revenue projections three years in a row.
  • The state’s growing dependence on “one shot” non-recurring budget solutions, including a retroactive $93.9 million cut in the state’s pension payment and the particularly dubious decision to trade $400 million in future tobacco bond settlement money for a $92 million one-time cash infusion to help plug an earlier $694 million budget gap in March.
  • The failure to increase the state’s “liquidity position” by increasing the surplus, which has been cut of state revenues and is inadequate to meet cover unexpected budget shortfalls, such as the two that occurred this spring.
  • Finally, a state economy that lags behind the national average and the region in economic growth and has yet to recover most of the jobs lost in the Great Recession of 2007-2009.
  • So why wasn’t the state’s rating dropped to ‘junk bond’ status? New Jersey has the nation’s third-highest average income, after Connecticut and Massachusetts, and it has a diversified economy. The state’s wealth means it has a sufficiently healthy tax base that state officials could raise taxes to solve the state’s current and long-term budget problems – even if Christie has ruled out doing so.

    Will the bond rating be lowered if the pension payment isn’t made in June? Probably not immediately.

    Fitch Ratings and Moody’s cut New Jersey’s bond rating earlier this month after the announcement of the latest $807 million budget gap in late April and have already factored in the likelihood that New Jersey would have to rely on such highly questionable “one shot” maneuvers as shifting the pension payment in order to close the deficit.

    Standard and Poor’s cut the state’s bond rating three weeks before the new budget shortfall was announced, but the nonpartisan Office of Legislative Services had already forecast at least a $526 million combined shortfall for FY14 and FY15.

    In any event, New Jersey’s long-term budget picture is largely unchanged by the latest shortfall – which is a one-time occurrence caused by the shift of hundreds of millions of dollars of income by wealthy taxpayers from 2013 into 2012 to avoid an increase in the top income tax bracket.

    If the state fails to make long-term improvements in its fiscal situation next year – or if Wall Street’s bull market, on which New Jersey depends so heavily for its income tax revenues, turns bearish – another round of rating cuts next year would not be unlikely.