5 Reasons Why You Should Care About A Bond Credit Downgrade
Is it really necessary to have a TV at a gas pump?
I’m seeing these more often, and I think that I’m against the concept. Like many Americans, I like to stare off into space while I’m pumping gas- a bit of a mental break. Well, at least gas prices are at historic lows, which is good for consumers- but bad for ExxonMobil. In fact, Standard and Poor’s recently downgraded ExxonMobil’s credit rating from AAA (their highest rating) to AA+, based partly on low oil prices. A bond downgrade can have a huge impact on the value of your bonds, so it’s important to understand these key facts:
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#1 Credit ratings have a huge impact on borrowing costs
A credit rating is simply as assessment of a particular firm’s creditworthiness and this term differs from a credit score, which is applies to credit for individuals. Whether you’re a consumer or a large corporation, however, you’ll pay less in interest if your creditworthiness is high. If a company has a low borrowing cost, it can afford to borrow more money to finance the business.
#2 Carrying debt isn’t necessarily bad- if you can swing the payments
Some financial professionals make it sound complicated, but there are two basic ways to raise money to run your business: stock (equity) and debt. The total amount of money you raise is referred to as your firm’s capitalization. If a firm can generate consistent earnings, lenders are more likely to loan money to the business.
Utility stocks are a great example. As you read this post, you might be using electricity, which is a product everyone uses. Utility companies use their steady stream of revenue from customers to generate consistent earnings, and they can afford to pay interest consistently. As a result, most utility firms raise the majority of their capitalization through debt.
A startup company without consistent earnings, on the other hand, does not have the ability to borrow money from lenders at a reasonable interest rate. These firms attract capital through equity investors who buy the stock on the expectation that the company will grow rapidly- along with the stock price. Microsoft is a great example, since it did not raise any capital through issuing debt for decades. Only in recent years has the firm issued debt securities.
#3 Revenue source has alot to do with the credit rating
A bond’s credit rating also depends on how the revenue is generated. Not simply how much revenue- but how the entity generate revenue and earnings.
Let’s expand the discussion to municipal bonds, which may be issued as revenue bonds or general obligation bonds. Revenue bonds are backed by fees charged by a facility- a toll road charges tolls and new stadium may be supported by fees paid by season ticket holders. In this case, there is a specific facility built, which is backed by specific fees.
General obligation (G.O.) bonds, on the other hand, are backed by the ability of the government entity to tax residents. School districts, for example, drive most of their general obligation money from property taxes.
#4 Pension liabilities can hurt a municipal bond’s credit rating
A growing problem with cities and states is the inability to fund their future pension liabilities for former employees. I’ve written about this issue in the City of Chicago and the very difficult “Catch 22” situation there. The city has a $30 billion pension crisis, because state law requires that the pensions must be funded. The city itself has declining tax revenue and the State of Illinois has its own financial crisis, which means that the state cannot help the city.
If you own municipal bonds, talk to your financial advisor about the risk of unfunded pension liabilities related to any bonds you own. This issue can end up in a credit rating downgrade, which will trigger a sharp decline in the price of your bond.
#5 Understand how your bonds are taxed
The typical investor may own bonds issued by corporations, municipalities, government agencies or the U.S. treasury. Bonds may be owned individually, or packaged in a mutual fund. And there’s one more wrinkle: investors may own bonds in a taxable account, or in a tax-deferred retirement account.
How your bonds are taxed can be really confusing, given all of these variables. A Honolulu CPA can review your investment statements and your 1099-INT tax forms to clarify the taxes you’ll pay on your bond holdings.
Use these tips to educate yourself on bonds and credit ratings. As always, these posts are for informational purposes only. Consult a financial or tax advisor as needed.
Ken Boyd
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
(email) ken@stltest.net
(website and blog) https://www.accountingaccidentally.com/
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