Bond sales are used by the state to borrow money from investors. As with any investment, investors look at two key factors when purchasing bonds: the rate of return and the risk of loss. The higher the rate of return, the greater the risk some investors are willing to incur. Conversely, investors will accept a lower rate of return on a safer investment opportunity. For bonds, this means that if it is more likely that a state can repay its debt, the state will obtain a lower interest rate on its bond issues.
In the United States, credit ratings for each state are determined by three private investment houses: Moody’s Investors Service, Standard & Poor’s Rating Services, and Fitch Ratings. Each house uses similar rating systems: the highest bond rating is AAA for Standard & Poor’s and Fitch; Aaa for Moody’s.
These credit ratings indicate each state’s ability to repay its debt. The higher the rating, the “safer” it is to lend money to that state in the form of a bond. A high bond rating permits the state to repay bonds at a lower interest rate. Lower rates, in turn, enable the state to borrow money at a lower cost and thus entail a more efficient use of public revenue. If a state’s ratio of debt to revenue becomes too high, its bond rating may fall, with the result that the state will have to pay more in interest to borrow money.
Although North Carolina has typically enjoyed the highest bond rating possible, Moody’s
Investor Services downgraded North Carolina’s credit rating one level, from Aaa to Aa1 in August 2002. Moody’s specifically attributed the downgrade to “the state’s continued budget pressure, its reliance on non-recurring revenues, and its weakened balance sheet.”
The downgrade marked the first time since 1960 that the state did not have an Aaa rating.
As a result of Moody’s decision, interest rates on bonds sold by the state increased by an estimated 0.05 percent on the August 2002 bond market. A report issued by the University of North Carolina predicted, “The additional cost in debt service would total $292 per million dollars in bonds per year over the course of the bonds.”
According to Jason White of the Pew Research
Center’s Stateline.org, “Bond ratings are often regarded as a report card on government performance because the analysts who produce them are among the few players in the state budget game who don’t have an obvious political axe to grind.” At the same time, the threat of a downgrade in bond ratings has been used in the past – for instance, during the 2001 long session – as a justification for raising taxes.
On January 12, 2007, State Treasurer Richard Moore announced that Moody’s had upgraded the state’s bond rating to Aaa – making North Carolina one of only seven states (Delaware, Georgia, Maryland, Missouri, Utah and Virginia) to enjoy a triple A rating from all three agencies. “The superior ratings from all three agencies are evidence of the confidence the market has in our state and in our bonds,” claimed Moore. “It means that North Carolina can borrow at the best rates possible.” According to Moody’s the upgrade was the result of “conservative budgeting, tight expenditure controls, and an improving economy.” The Department of the State Treasurer also explained the upgrade by referring to “the state’s strong financial performance, relatively moderate debt burden, effective management, healthy financial outlook, replenishment of reserves and recent economic gains” – actions generally thought to embody a “conservative approach” to budget management.
Investment houses use a variety of factors in assessing a state’s bond rating. The most basic is the state’s ability to take on new debt and manage existing debt as measured, in particular, by the percentage of state revenue dedicated to debt service, i.e. payments on principal and interest. According to Standard & Poor’s, most states with a AAA rating also have a “clearly articulated debt management policy.”6 Other factors, such as demographic trends, that affect state debt per capita are also taken into consideration. What is most important, however, is the likelihood of a state balancing its budget. In this respect, spending increases should not outpace revenue. What counts as well is the manner in which the budget is balanced. For instance, using nonrecurring funds to pay for recurring programs is frowned upon. In 1990, for example, North Carolina was placed on Standard & Poor’s CreditWatch list over concerns that the state was relying on “one-time solutions” to address “long-term” budget shortfalls. Instead, the agency cautioned, North Carolina needs to address budget shortfalls by enacting “permanent revenue increases or spending reductions.”
Contrary to what critics on both sides of the aisle might claim, tax structure seems to have little effect on a state’s bond ratings.
North Carolina’s debt service burden (as of 2005) as a percentage of General Fund expenditures is 2 percent. By contrast, a burden of 6 percent is thought to be “moderately high.” Hawaii has the highest per capita debt burden in the country ($3,336) followed by Connecticut ($2,820) and New Jersey ($2,800). As of 2005, North Carolina’s per capita debt burden was $742.