November 7, 2013

Rob Williams

Cooper J. Howard

Key Points

• Population growth, outstanding debt and revenues, and financial discipline drive the relative credit strength of U.S. states.
• Credit ratings tend to drive the market’s perception of each state’s credit risk, as well as corresponding yield.
• Overall, the credit strength of most U.S. states appears strong, but if you’re concerned about credit quality, avoid the outliers or add other states to your portfolio.

How can I determine which states to invest in? This is one of the most common questions about municipal bond investments. While the answer will depend on the individual’s specific situation, it’s also important to know the characteristics analysts look at to assess the relative strength of each state. Other than the political will and flexibility of state politicians, our view is that there is no one individual characteristic more important than another. It is the combination of characteristicsall combined in the credit ratingthat corresponds to a higher or lower-rated state credit quality. It’s also worth noting that no state has defaulted on debt since the Great Depression, and states are not legally allowed to file for bankruptcy.

Population growth and a diverse economy generally help. Most states generate a large proportion of their revenue from sales and income taxes, with much of the rest being made up by federal support. A growing and fully employed tax base is typically supportive of greater income taxes today and in the future. Rust belt states with stable or declining populations may have stagnating economies, and higher unemployment, as well. States with vibrant in-migration and population trends tend to have expanding economies, and lower unemployment.

Population and employment characteristics of selected state issuers 1

Sources: U.S. Census for 10-year population growth rates, as of July 2010, Bureau of Labor Statistics for unemployment rate, as of August 2013.

Note: Data is sorted by August 2013 unemployment rate.

Debt and revenues are also critical. The amount of a state’s net tax-supported debt per capita, or its debt serviced by direct or special tax revenues minus its self-supporting obligations, as well as its funded pension level, are also important factors. A lower debt per capita number generally indicates a greater ability to meet outstanding liabilities through tax revenue alone. A higher funded pension level shows the state is better positioned to meet its future obligations. Many states with more proactive legislatures have achieved higher funded pension levels by reforming pension and healthcare benefits, often reducing those benefits for new and occasionally existing employees. Another thing to keep an eye out for is how effective a state is in managing its budget. States that operate with budget surpluses, as opposed to chronic shortfalls, typically have greater flexibility to meet their bond payments.

Selected issuers ranked by per-capita debt burden 1

Sources: Moody’s Investor Services (2012 State Debt Medians Report) for net-tax supported debt per capita, as of May 22, 2012, Standard & Poor’s Rating Services (A Bumpy Road Lies Ahead For U.S. Public Pension Funded Levels) for funded pension level, as of July 16, 2013, Center of Budget and Policy Priorities for budget shortfalls, as of June 27, 2012

Note: Michigan does not have a projected budget shortfall for 2013 and is therefore not included. Data is sorted by net tax-supported dept per capita.

Credit ratings remain a good place to start. Credit rating agencies analyze the data we’ve outlined, along with other important factors, to assess a state’s ability to meet its debt payments. The two major rating agencies, Standard & Poor’s and Moody’s Investors Service, have also publicly announced efforts to refine their rating criteria to factor in more direct issues such as pension funding. Remember that ratings are opinions and not guarantees of credit quality. While rating agencies have their critics, the ratings on municipal bonds have correlated highly with historical defaults and tend to reflect the market’s perception of credit risk.

Consider the tradeoffs you may need to make. There are also tradeoffs to consider, of course, when building a diversified state muni portfolio. One is that yields in states with higher ratings tend to be lower than those with lower ratings, and higher credit quality. In addition, if you choose to diversify out of your home state, you may not get the full tax benefits of municipal bonds. Municipal bonds are often free of federal income tax, and may be exempt from state income tax as well, although municipal bonds issued for certain purposes may not be tax exempt. Interest payments on bonds issued in the investor’s home state are generally exempt from state income taxes, which can be particularly beneficial if you’re in a state with a high state tax rate. If you’re concerned about exposure to a single state, consider diversifying into other issuers within that state, or add bonds from other statesjust remember that you won’t get the state-tax exemption on muni bonds from outside your home state. To calculate the tax equivalent yield, you can use the online calculator found here.

Selected state issuers’ credit ratings and general obligation bond yields 1

Source: Bloomberg, data and yields as of 10/31/13

Note: Colorado is not included as it does not have any outstanding general obligation bonds. Data sorted by Moody’s credit rating.

What to do now

Overall, the ability of most U.S. states to pay their debts, in our view, is strong and has improved significantly since the end of the Great Recession. But, if you’re worried about credit risk, avoid the outliersor diversify your portfolio. The tradeoff may be a greater personal tax burden, but also potentially less credit risk in your muni portfolio.

1. Note: The states selected were chosen because they are the states with the largest amount of outstanding municipal bonds in the marketplace. They are not to be used as a specific recommendation for a buy or sell.

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Next Steps

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