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Municipal Bonds

The state of the states is strong

Municipal Credit Research Team
Experienced sector specialists represent one of the industry’s largest credit research teams dedicated to municipal investing.
A staircase inside a glass building

State and local government credit quality improved in 2021, bolstered by strong economic growth, a recovering labor market and an influx of federal stimulus. Now we see speculation about a looming recession and slower revenue growth, as well as a possible fiscal cliff. Although some caution may be warranted, state and local governments are much better off than before the Great Recession.



Credit Report

Governments have benefited from federal stimulus

Since the onset of the pandemic, state and local governments have benefited from substantial federal stimulus. The Coronavirus Aid, Relief and Economic Security Act (CARES Act) signed into law in March 2020 provided $150 billion in general assistance for domestic governments. Of that amount, approximately $139 billion was allocated to states based on population, with no state receiving less than $1.25 billion. CARES Act funds were intended to assist with necessary expenditures incurred due to the pandemic, such as health care spending, small business support and unemployment benefits.

State and local governments were subsequently allocated $350 billion in direct aid provided under the March 2021 American Rescue Plan Act (ARPA). State and local governments have much more flexibility in how they can use ARPA funds. Recovery funding was disbursed in two tranches of approximately $195 billion and $130 billion. Territories will receive a total of $4.5 billion. The deadline to commit the funds is 31 Dec 2024 and spending must be completed by 31 Dec 2026.

Most states have already deployed most of their ARPA funds. As of the first quarter of 2022, approximately one-third of the funding remains to be spent. So far, six states (CA, IN, ME, MT, NC and WA, along with Puerto Rico) have appropriated all or nearly all of their ARPA funds. Three states (MS, NE and SC) had allocated little funding by the end of the first quarter, but plan to allocate funds as part of their 2023 budget and legislative cycle.

Stimulus has helped states balance budgets

States are using their flexible aid to offset declines in their revenue collections and to address the health, economic and fiscal impacts of the pandemic. The largest portion of the funds to date has been used to replace state revenues that fell below projected levels in FY20. This enabled states to balance their budgets and avoid funding cuts for schools, health care and other services.

While much of the federal funds spending has been for one-time uses, some states are deploying the funds for the benefit of various state services, such as affordable housing, mental health services or job training. Other spending choices include rebuilding unemployment insurance trust funds, financing economic development initiatives, improving water/sewer infrastructure and boosting broadband access. The expressed purpose of the federal funds is to provide relief from the economic and health toll of the pandemic, though some states are using the funds for larger capital projects.

State and local government tax collections were robust in 2021. The positive growth continued in the first quarter of 2022, with total tax revenues up 6.3% from the fourth quarter of 2021, and up 21.3% compared to the first quarter of 2021. Citing weakening macroeconomic trends, most states have projected a slowdown in tax revenues for FY23. At the same time, states are also adjusting expenditures to minimize budgetary reliance on one-time federal aid for operating support. A sizable portion of state and local fiscal recovery funds remains unspent, providing governments with an important fiscal cushion.

States are in a stronger position to weather a recession

State debt levels rose 2.5% in 2020 and 4% in 2021, the fastest pace in five years. Historically low interest rates set the stage. Yet, according to S&P, the median debt-per-capita in 2021 was $984, still below the peak of $1,036 in 2012. A combination of higher borrowing costs from rising interest rates, economic contraction and, perhaps, less flexibility on other fixed costs like pension payments is likely to put a check on the governmental appetite for debt issuance in the near term.

States have focused on strengthening their fiscal resilience by building up reserves.

Since the Great Recession, and especially during the pandemic, states have focused on strengthening their fiscal resilience by building up reserves. During FY21 alone, states grew their collective rainy day funds by $37.7 billion, or an increase of roughly 50% from a year earlier. This drove the total held among all states to a record high of $114.6 billion. State governments are less likely to draw down their reserves, at least while there’s unspent federal aid or other savings to be tapped.

The specter of the Great Recession in 2007 – 2009, which depleted many states’ coffers, looms large in the recent background. Unlike 15 years ago, the states are in a stronger position to weather a recession or economic downturn. According to the Pew analysis of data from the National Association of State Budget Officers, the 50-state median for the days each state could run government operations on rainy day funds alone was 34.4 for FY21, compared with 17.3 days just before the Great Recession.

Pension funds adjust for investment losses

Pension funded ratios were up in 2021 based on strong market performance, with many plans realizing investment returns of more than 20%. This increased the average public pension plan funded ratio to more than 70%. Unfortunately, much of last year’s improvement is expected to be lost due to poor market performance in 2022.

Based on year-to-date results, investment return losses have averaged about 10%. S&P projects typical pension plans will see a negative 7% return based on market performance through 30 Jun 2022. Such losses are well below the assumed rates of return for most plans, which tend to be in the neighborhood of 7%. On the positive side, less than 10% of state and local plans assume returns of 7.5% or greater.

Falling behind the assumed growth rate will erase some of last year’s gains, and funded ratios for many state and local pension plans are expected to lose ground. As of May 2022, the funded ratio of the 100 largest U.S. public pension funds was estimated to be just over 78%, down from a high of 85% reached last year. Because pension contribution formulas often incorporate market returns into funding models, some plans saw their required contributions drop in FY22.

In contrast, poor returns in 2022 should lead to higher contribution requirements for some plans in FY23, though the impact will be muted by smoothing practices. It’s worth noting that several states (IL, CT) made supplemental pension contributions over the last year, taking advantage of stronger revenues to shore up long-term liabilities. Volatility in returns between 2021 and 2022 highlights the challenges facing plans with lower funded ratios. In many cases, consistent contribution increases will be needed to improve funded ratios.

Rising inflation means higher pension benefit payments

Investment losses are not the only factor pressuring pension assets. For many publicly sponsored plans, benefit payments are impacted by cost of living adjustments often indexed to inflation. Rising inflation translates to growing benefit payments and more pressure on pension assets.

Governments contending with revenue losses or operating budget pressure may consider reducing pension contributions to provide budgetary relief, but this is not expected to be the norm. Most states are expected to fully fund required contributions, despite possible budgetary pressure. A lack of funding discipline combined with deteriorating funded ratios could put negative pressure on some ratings.

Overall, state government credit is resilient. States experienced record-high surpluses in 2021, socking away a good part of those excess revenues for a rainy day and paying down long-term liabilities. The overall debt burden for states remains manageable. Federal Covid-19 relief aid provides even greater budgetary flexibility for state and local governments. A spate of rating downgrades is not expected, even if we were to see slower growth in tax collections, negative investment returns or higher borrowing costs.

Rising inflation translates to growing pension benefit payments and more pressure on pension assets.
November promises notable ballot initiatives

Voters will decide several important issues in the upcoming November elections that may impact the municipal bond market. Many state initiatives will ask whether to increase or decrease income taxes, which could directly impact demand for municipal bonds. Three states (CA, MA, ID) are asking to increase personal income taxes. Two states (CO, AZ) are pursuing tax decreases, or to make tax increases more difficult to implement.

Other states are asking for budgetary flexibility, or to legalize marijuana. While these measures are not likely to have a direct impact on the demand for municipal bonds, they may have an impact on a state’s credit profile. Three states (MD, OK, SD) will decide if the recreational use of marijuana should be legalized and taxed. Ballot measures in Maryland and South Dakota seek the legalization of adult-use recreational marijuana and, in the case of Maryland, it directs the legislature to pass a law for the use, distribution, regulation and taxation of the drug. In Oklahoma, the state is voting to legalize marijuana which, if the vote passes, will be taxed at 15%. These taxes would generate a new revenue source for these states and would support each state’s General Fund and numerous spending priorities.

Challenges remain in these states, even if the propositions to legalize marijuana are passed. The federal government classifies marijuana as an illegal substance, so banks are reluctant to do business with marijuana cultivators and dispensary owners. As a result, medical marijuana sales and production have become a cash-driven business, which makes it difficult to audit businesses and track and tax cannabis sales.

Figure 1: Muni treasuries table
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Fitch Ratings, 2022 U.S. State Medians, Strong Metrics Suggest State are Prepared for Volatility, 21 Jul 2022

S&P Global Ratings, Pension Brief: 2022’s Down Markets Reverse 2021’s Unprecedented Gains For U.S. Public Pension Plans, 08 Jun 2022

Public Pension Funding Index – June 2022, Milliman.com

“Budget Surpluses Push States’ Financial Reserves to All-Time Highs,” The Pew Charitable Trusts, 10 May 2022 (pewtrusts.org)




Center on Budget and Policy Priorities (https://www.cbpp.org/sites/default/files/11-29-21sfp.pdf)

Congressional Research Service (https://crsreports.congress.gov/product/pdf/R/R46298)

National Conference of State Legislatures (https://www.ncsl.org/research/fiscal-policy/how-states-are-spending-their-stimulus-funds.aspx)

California Secretary of State, Qualified Statewide Ballot Measures

Oklahoma Secretary of State, Questions 818 and 819

Colorado Secretary of State, 2021-2022 Initiative Filings. #31 State Income Tax Rate Reduction.

Ballotpedia.org, Maryland Marijuana Legalization Amendment, House Bill 837

Ballotpedia.org, South Carolina Capital Reserve Fund Increase Amendment (2022)

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Investing involves risk; principal loss is possible. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurer’s ability to meet their commitments.

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