On Thursday, September 3rd, the Commonwealth of Kentucky received a credit rating downgrade from Standard & Poor’ Rating Services. The rating cut lowered the issuer credit rating on Kentucky to ‘A+’ from ‘AA-‘, and the rating for appropriation debt was lowered to ‘A’ from ‘A+’.
According to the S&P report describing the rationale for the rating change, “The downgrade reflects our view of Kentucky’s substantially underfunded pension liabilities that are the result of chronic underfunding and that we view as placing long-term pressures on the state’s finances.”
While the rating was downgraded, the outlook remains stable. “The stable outlook reflects our expectation that Kentucky will maintain a strong ability to fund its debt obligations as they come due despite long-term pension-related pressures that are likely to make true structural balance a challenge.”
The fact that Kentucky has dealt with pension related difficulties for some time is not breaking news. However, the rating change reflects the fact that Kentucky’s leadership has not done enough to address the issue, which has slowly deteriorated over the past few years. The fact that the trend in unfunded pension liabilities has worsened is a key justification for the rating change. Per the S&P report “until the state implements and demonstrates a track record of addressing its long-term pension liabilities, we are unlikely to raise the rating, even if revenues and the economy outpace current forecasts.”
Going Forward
For banks that have exposure to Kentucky bonds in their investment portfolio, the question now becomes what to do going forward. The first thing to note is that the outlook for Kentucky remains stable. There is no immediate need to divest your portfolio of its Kentucky holdings. Second is that Moody’s and Fitch have not adjusted their ratings on the state. While it is a possibility that they may follow suit, this has not happened as of yet. Third, recent new issue Kentucky deals brought to the market have been trading at levels similar to those seen prior to the downgrade.
Monitoring the credit quality of your bank’s Kentucky holdings will be especially important. This goes above and beyond using credit ratings, and should include things such as employment statistics, tax revenues, and demographics, to name a few. This information can be found in issuer’s Ratings Reports and/or Official Statement (emma.msrb.org).
Diversification is another best practice that can help minimize portfolio risk. The old saying “don’t put all your eggs in one basket” applies perfectly here. While banks across the country tend to be comfortable owning bonds issued by their home state, do not be afraid to venture beyond your borders. Looking at issuers in different states can provide opportunities to find strong credit quality and high relative value that might not exist at home.
Taylor Advisors, Inc. is a balance sheet consulting firm and a registered investment advisor based in Louisville, Kentucky. We help banks improve or maintain profitability while managing interest rate risk – what we call Balance Sheet Management (BSM). Additionally, Taylor Advisors’ investment consulting/advisory services assist with strategy formation, portfolio diversification, credit monitoring, and tax minimization strategies, including municipal bonds and investment subsidiaries.
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