ETF Trends
ETF Trends

Rhode Island. The Ocean State. Little Rhody. It is officially the smallest U.S. state in area but the second most densely populated with a little over one million residents as of a 2012 census estimate. It was also the first of the original 13 colonies to declare independence from British rule.

U.S. States with Highest Population Density

Source: U.S. Census Bureau as of 2012.

Why this little civics refresher? Rhode Island is at the heart of a serious discussion centered on the “moral obligation” to pay a debt, according to a recent Reuters article.1 The bonds were issued for the benefit of a failed business enterprise belonging to former Red Sox pitcher Curt Schilling, and the article asserts that the state has no “legal” obligation to pay the debt.

However, since as far back as the Revolutionary War and the subsequent adoption of the U.S. Constitution, debts incurred by states have been deemed valid obligations to be met. States, as we might be reminded by legal scholars, are generally required to observe their contracts and meet their debt obligations.

Philip Fischer points out in his 2013 book, Investing in Municipal Bonds, that state and local governments have generally met their obligations because access to the capital markets is critical to facilitating long-term growth and economic stability. Thus the concept of an “obligation,” whether general, moral, or implied, has specific grounding in statehood.

On Monday, Standard & Poor’s Ratings Services warned of a possible downgrade to Rhode Island’s “AA” credit rating if the state does not meet its obligation for the Curt Schilling bonds. Were it not to pay, the state’s cost would be measured in higher interest rates for its debt.

Though failure to follow through likely will not be catastrophic, in my opinion, it will send a resounding message to municipal bond investors that a cornerstone element of the municipal capital markets is being tested.

1Rhode Island Will Be Downgraded if Schilling Debt Defaults-S&P, Reuters, May 12, 2014.