Sunday, March 2, 2008

Bond Ratings Explained

In my February 29, 2008 posting ("Warren Buffett's Letter..."), I mentioned that California's bonds were rated the second-worst in the entire country (single A). Why is this problematic? Two reasons: 1) the relatively low rating shows that the health of the state economy isn't as stable as it could/should be; and 2) low bond ratings mean that future expenses may exceed future revenue, making borrowing for new projects (think schools, tax credits to the poor, new roads and bridges, etc.) prohibitively expensive. In short, Californians may not be able to maximize funds for future generations if bond ratings do not improve.

Let me put this in perspective. California's rating is A. Investment grade bonds are bonds rated in the top four quality categories by either Standard & Poor's (AAA, AA, A, BBB) or Moody's (Aaa, Aa, A, Baa). Some readers might think that the credit risk assessors have rated Californian bonds in the top three, so there is no problem. But, as I stated above, California has the second worst rating in the nation, which means that the accountants who have studied our expected revenue and expenses are saying that our economy is projected to be the second worst place to invest in the entire United States. Moreover, our lower bond rating means that we have to pay a higher interest rate if we want to borrow money, which, over time, could create more liabilities for our children in the form of billions of dollars of interest payments. Other than mis-management and the irresponsibility of our elected representatives, there are no reasons why liberal Oregon, post-Big-3 Michigan, low-growth West Virginia, and high-growth Texas should be able to issue higher-grade investments than California.

Furthermore, California's economy is one of the top ten largest economies in the entire world, so its low bond rating means that the state is not budgeting well at all (i.e., our elected representatives are concealing future costs, or enriching themselves or their lobbyists' pet projects at our expense), and if we enter a recession, the effects would be felt world-wide. As a result, this bond rating exposes a crack in California's economy that could potentially impact not just you, but that 13 year old kid in Thailand who makes clothing to sell to us.

I own a T. Rowe price international bond fund. In my bond fund, 56% of the bonds held have higher ratings than California's bonds. The bond invests primarily in Austria, Malaysia, Italy, Japan, France, Germany, and the United Kingdom. Already, some of T. Rowe Price's investors have basically decided, "Why invest in California if you can get an equivalent, more stable return internationally?" Meanwhile the EU's GDP is now equal to the U.S. It doesn't it take a genius to figure out what will happen if this trend continues. We must take measures to fix these issues lest the price of oil and other major commodity indices become denominated in euros (or some other currency), causing Americans to spend the majority of their days working to pay taxes to Washington, D.C. so that our representatives can use those funds to send payments abroad.

For a more in-depth explanation of bond ratings, see

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