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Summary

Can a state default? And what would that mean for those who hold municipal bonds? There is no law allowing states to file for bankruptcy; and filing for bankruptcy is not an easy endeavor. While some states have pension liabilities that impact their financial health, the fiscal health of a state is defined by more than just its debt; a state’s income, assets, and liabilities all work together to define its health and credit rating. In the end, holding a diversified portfolio of national municipal bonds in your portfolio helps to provide income and diversify your assets.

 

State fiscal pressures driven by the crisis

Fiscal pressures associated with combating COVID-19 are driving a new fear of potential state bankruptcies. For investors who own the more than $1.2 trillion in outstanding state-issued municipal bonds, this raises an alarming prospect: Could states default on their obligations to repay investors?

 

No current state bankruptcy law

Unlike for individuals, companies, and municipalities, there is currently no law in place to allow states to file for bankruptcy. Subsequently, Congress would need to change this law, but it seems unlikely given its current makeup. Further, and perhaps most importantly, to meet conditions of insolvency, states would need to convince a bankruptcy court that it’s exhausted all other means to satisfy its debts. Such efforts would include reducing workforces and selling off state-owned property, including forestland, natural resources, parks, buildings, and more. Even California, with its more than $1 trillion in outstanding debt including unfunded pension liabilities, would have a hard time convincing a court that it’s destitute when, in fact, the state owns more than 14 million acres of forestland, over 300 parks, and other valuable property in what is arguably the world’s most expensive real estate market.

 

Pension liabilities: A drag on fiscal health

While bankruptcy is not a likely option, some states hold sizable liabilities on their balance sheet that are largely due to unfunded pension liabilities. This is not a new concern, but it is exacerbated by COVID-19. In 2017, U.S. states collectively had nearly $4.2 trillion in unfunded pension liabilities which was nearly four times greater than the entire amount of outstanding state-issued debt. For example, California’s pension liabilities, estimated to exceed $1 trillion,[1] dwarf the state’s outstanding $155 billion in municipal bonds. Yet the state currently allocates only 11% of its $175 billion budget to funding pensions. Just to keep its pension liabilities from growing, California would need to allocate a staggering 26% of its total annual budget to funding promised pension benefits. For this reason, most states are in dire need of pension reform.

 

States enjoy strong credit ratings

Despite elevated pension liabilities, nearly all states continue to enjoy relatively strong credit ratings. Given such enormous debt and pension liabilities, how can most states continue to have such strong credit ratings?

The reality is that debt doesn’t tell us much about the fiscal health of a borrower. Lenders want to compare a borrower’s debt to their income or assets. For example, the California economy is a highly diversified, $3.1 trillion annual juggernaut. Even with a total estimated debt of over $1 trillion, at only 38% the state’s debt-to-GDP ratio is a mere fraction of that of the federal government’s, which currently stands at about 110% debt-to-GDP. In fact, the average debt-to-GDP ratio of all states stands at only about 25%. And as mentioned previously, states also have substantial assets that have been pledged as collateral for their debts. Subsequently, for these reasons and more, California currently enjoys a credit rating of Aa2 from Moody’s (the agency’s third highest rating).

 

Five most heavily indebted states by debt-to-gross domestic product

Five Most Heavily Indebted States (by Debt-to-GDP)
State GDP (thousands) Total Debt (including pension liabilities) Debt to GDP Ratio
Alaska                                               54,851,000                                               24,560,559 44.78%
Illinois                                            879,947,000                                            388,775,647 44.18%
Mississippi                                            115,749,000                                               48,421,821 41.83%
Kentucky                                            211,621,000                                               85,223,203 40.27%
New Mexico                                            101,452,000                                               40,475,430 39.90%

Economic diversification and balance sheet strength are also important considerations when evaluating state finances.  In Alaska, an estimated 85% of the state’s tax revenues come from taxes on oil and oil-related services. However, due to the state’s overreliance on oil as a primary source of revenue, Alaska today is the most heavily indebted state in the country relative to GDP. Does this mean Alaska is a bad credit risk?  Not necessarily. The state obviously has considerable wealth due to its natural resources and the Alaska Permanent Fund, a $66.3 billion investment fund. Subsequently, Alaska, like California, continues to enjoy a relatively high credit rating of Aa3 from Moody’s (the agency’s fourth highest rating).

 

Investor implications

First, despite heavy pension liabilities, states’ default risk appears relatively low. Credit ratings appear strong and there are no laws in place for states to file for bankruptcy; even if there were, it seems unlikely they could convince a bankruptcy court that they were indeed insolvent.

Second, investors are compensated for assuming the added credit risk associated with investing in municipal bonds over equivalent-duration U.S. Treasury bonds. For example, the average yield for a 10-year California municipal bond is currently about 2.5%. Given the tax-exempt treatment of municipal bond interest, that works out to a taxable equivalent yield of nearly 4%. When compared to the current yield of 0.60% on fully taxable, 10-year U.S. Treasury bonds, investors currently earn a 3.4% premium for taking on the added risk of owning the state’s municipal bonds.

 

Taxable equivalent yields for select states

Yield on 10-Yr Bond Taxable Equivalent Yield @ 37%
New York 2.75% 4.37%
Illinois 2.00% 3.17%
California 2.50% 3.97%
Texas 2.25% 3.57%
New Jersey 2.00% 3.17%
US 10-Yr Treasury 0.62% 0.62%

Finally, investors should seriously consider owning a diversified portfolio of national municipal bonds. For those investors with state-specific tax constraints, diversification needn’t always come at the expense of tax benefits. There are states with reciprocity agreements in place that exempt citizens of their states from the taxation of interest paid on select states’ municipal bonds. Subsequently, even those investors facing state-specific tax constraints can achieve a relatively high degree of diversification by owning issues from those states that have reciprocity agreements with their home state.

[1] Stanford University Pension Liability Map FAQs http://web.stanford.edu/~rauh/faq/index.html

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