Can States Surpass U.S. Government in Credit Ratings?

On August 1st, Fitch downgraded the U.S. credit rating from AAA to AA+. Among other concerns, the rating agency cited eroding confidence in fiscal management as illustrated by repeated debt-limit standoffs.

Current ratings of the U.S. now stand at AAA by Moody’s, AA+ by S&P (who downgraded the US in 2011), and Fitch at AA+. These three independent companies evaluate the financial strength of borrowers on a scale where the highest rating is AAA, the second highest is AA+, and so on, all the way down to D. The lower the rating, the higher the potential for default.

The question arises: can a state’s rating be higher than the country’s? While a state can feel stress when its Country experiences fiscal weakness, we do not believe state and local government defaults will increase, nor will municipal borrowers become ambivalent towards maintaining their ratings.

The federal government’s strengths as a borrower include willingness to pay and an ability to print money. While municipal borrowers do not have the latter, unique attributes to tax-exempt debt enhance their securities. This feels like a good time to remind everyone of what they are.

Cashflow vs. Projects

The purpose of federal debt is often cash flow. It is one of the federal government’s mandates, and we point out this difference not as a censure of federal operations but as a meaningful difference in how debt is used. The U.S. government often meets its annual operating expenses through newly issued debt. Conversely, municipal debt is issued mainly for capital projects which require a higher level of budget discipline and justification.

Local Voters Rein in Borrowing

Many local government bonds are issued only after a successful vote. Residents approve a project like a new school building, community hospital, or repaving program and dedicate a specific revenue stream to repay the debt. In addition, many states and municipalities have limits not just on the amount of debt that can be borrowed but also on repayment terms, ensuring stable long-term planning.

Municipalities Lead: Low Debt Service

Healthy states and local governments have manageable annual debt service payments. If expenses are out of line, it is unlikely due to debt-carrying costs, and the ramifications of nonpayment are much larger than cutting other line items, as painful as they can be. Decreasing library hours, reducing per-student spending, or increasing a tax rate are all easier to reverse than a poor credit history.

The above comments underscore the unique strengths of municipal debt issuers and why we believe a state or city can pierce the U.S.’s rating ceiling. While ratings measure the likelihood of distress, the criteria measured differ from a sovereign. Still, federal weakness will impact the municipal market. State and local governments will experience higher borrowing costs as municipal bonds strongly reflect Treasury pricing. The silver lining is the higher borrowing cost penalty for weaker borrowers incentivizing rating maintenance. While we see the potential for increased pressure on states and local governments, we do not expect municipal default rates to be affected by this downgrade.

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