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Sacramento County Receives Bond Downgrade

Sacramento County Receives Bond DowngradeIn big news for Sacramento County last week, the international, “Big three credit rating agency” Fitch Ratings downgraded the municipality’s Pension Obligation Bonds (POBs) and Certificates of Participations (COPs).

For those unfamiliar with what this actually means and how it may affect you, let’s take a look at what these financial instruments are.

Sacramento County Receives Bond Downgrade

A Pension Obligation Bond or POB is a bond that is issued by a state or local government to pay its obligation to its pension fund. These financing maneuvers allow states to counter pension liabilities by borrowing against future tax revenue. They are essentially a gamble that the investments will produce a higher rate of return than the bond’s interest. If portfolio returns do in fact beat the rate of the return issued to the bond purchaser, the fund makes money; if not, the liabilities become unfunded. Since these bonds are unconditional obligations imposed by law, the County is legally obligated to pay the liability. If the portfolio loses money due to a recession or another series of unfortunate events, it leaves the municipality scrambling for ways to make up for the difference, which was the case when Stockton and San Bernardino declared bankruptcy in 2012.

A Certificate of Participation or COP is another common type of financing used by state and local governments where an investor buys a share of lease revenue. This is sometimes referred to as “lease-backed financing”. With COPs the bonds are backed by dedicated lease payments from the municipality. As an investor, these types of bonds can be risky as they can be called before redemption, which means you may lose out on your full interest payment.

The Issuer Default Rating (IDR) is fairly straight forward. This is essentially a measure of the amount of risk surrounding the county’s ability to pay back its loan obligations. The primary reasons behind these downgrades came from several factors. First, Sacramento County’s employment levels and home values remain below pre-recession levels. Furthermore, Fitch expects that Sacramento County will spend more than they earn through revenue. Lastly, reserve revenue for the county is weak, and thus increases the risk of financial turmoil or even default, should a new economic downturn occur.

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