Boston - Every year, Eaton Vance's municipal bond research team ranks all of the U.S. states on their creditworthiness in a report entitled State of the States.
As would be expected after 10 years of economic growth, most states are in a strong financial position. In aggregate, state revenue is 12% ahead of the pre-recession peak on an inflation-adjusted basis, which has led to most states having balanced budgets, healthy liquidity balances and adequate pension funding. However, some states are still struggling with budget gaps, thin reserves and inadequate pension funding, which is a significant concern at this point in the credit cycle.
In the annual report, the research team evaluates a number of qualitative and quantitative factors to determine each state's credit quality. Some qualitative factors include: projected budget shortfalls or surpluses, historical record of meeting financial projections, pension reform initiatives and proposals to increase revenue or decrease expenses. Some of the specific quantitative factors we incorporate include:
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Debt, adjusted unfunded pension liability and unfunded OPEB1 liability as a percentage of gross state product: High levels of debt or significant unfunded retirement obligations can cut into a state's budget, reducing the amount of resources available.
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Adjusted pension liability funded ratio: The lower the ratio, the more a state may need to invest in its pension plans to meet future obligations, reducing flexibility for other spending.
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Governmental fund liquidity: High levels of liquidity ensure a state can make its payments on time, without the need for short-term borrowing.
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State unemployment rate: Low unemployment tends to correlate with higher economic growth, productivity and increasing state revenues from taxes.
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Median household income: When adjusted for cost of living, wealthier states tend to have higher revenue-raising flexibility and more economic activity.
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Real GDP growth: A growing economy increases incomes, raises governmental revenues and helps keep unemployment low.
Taking all of these and other factors into consideration, we believe the strongest five U.S. states, ranked in order are: Idaho, Wyoming, Utah, Nebraska and South Dakota. Conversely, we believe the weakest states and territories are Puerto Rico, Illinois, New Jersey, Connecticut and Kentucky.
Digging deeper on some of the weakest states: Illinois is struggling from intertwined problems of budget deficits and growing pension liabilities. However, after the November 2018 elections, Democrats now control all three branches of government, and new tax-raising initiatives could stabilize the budget. Meanwhile, New Jersey is hindered by structurally unbalanced budgets and rapidly growing pension and debt costs, and with one of the highest tax burdens in the U.S., raising additional tax revenue could be a challenge. In Connecticut, challenges include a state burdened by a struggling economy, and significant revenue volatility, but revenues have surpassed budget estimates in recent quarters, leading to improved reserves. Finally, poorly funded pensions, and a below-average economy drive Kentucky's low ranking.
Overall, it should be noted that beyond the states, there are over 40,000 different local general obligation (GO) and essential service credits. Moreover, in some highly ranked states, there are certain local issuers that may pose a credit risk. Conversely, in some low-ranking states, certain local issuers may exhibit strong credit characteristics.
Bottom line: Putting it all together, we believe independent, professional credit research is more important than ever in navigating the vast, disparate municipal bond market.
1OPEB: other post-employment benefits.
An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There generally is limited public information about municipal issuers. As interest rates rise, the value of certain income investments is likely to decline. Longer-term bonds typically are more sensitive to interest-rate changes than shorter-term bonds. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer's ability to make principal and interest payments. Investments rated below investment grade (typically referred to as "junk") are generally subject to greater price volatility and illiquidity than higher-rated investments. Derivative instruments can be used to take both long and short positions, be highly volatile, result in economic leverage (which can magnify losses), and involve risks in addition to the risks of the underlying instrument on which the derivative is based, such as counterparty, correlation and liquidity risk.
© Eaton Vance
© Eaton Vance
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