State Budgets Hit a Bumpy COVID-19 Road—Analyzing Municipal Credit Pressures

For most US governors, June typically brings political fireworks when state legislatures hammer out final budgets for the next fiscal year. Our municipal bond team provides an overview of its recent COVID-19 credit research, explaining why some states face mounting credit pressures from high fixed costs and shallow emergency reserves, whereas other states with more diversified economies and strong financial management should fare better post COVID-19.

View the full paper. An excerpt follows.

In the wake of the COVID-19 pandemic, US governors have grabbed the media spotlight. After issuing lockdown procedures and more recently guidelines on re-opening businesses, public awareness of the role governors play in state economies has risen sharply. Evaluating the willingness of governors to make tough financial decisions is a key factor in our municipal bond team’s credit research, which gauges bond risks. Whereas some buyers of state-issued bonds might not blink if bond yields are tempting enough, our COVID-19 credit analysis helps ensure we are appropriately compensated for risks in states where governors may have chronically shortchanged budgets and degraded financial resiliency.

With regard to credit risks, it’s important to state upfront that despite the COVID-19 recession, states aren’t heading toward bankruptcy. Under current federal law, states can’t file for bankruptcy—granting authorization would require new legislation at the federal level. That said, we think mounting credit pressures could mean ratings reductions for some states if more federal funding doesn’t materialize from the US Congress this summer. Some states were ill-prepared to weather a normal cyclical downturn, let alone the dramatic economic shock of COVID-19.

A downgrade could increase borrowing costs for states already weighed down by pension liabilities and meager rainy-day reserves. To a degree, this year’s muni market performance already reflects the variability of credit pressures among states.

To gauge the credit pressures from COVID-19 (and record low oil prices) that are bearing down on state budgets, our team analyzes four key components that can impact a state’s financial and economic resiliency. Our research combines quantitative metrics—for example, the diversity of tax revenues, exposure to at-risk sectors like tourism and the size of “rainy day” reserves—and qualitative measures that consider the strength of a governor’s ability to implement hard choices like spending cuts or new taxes.

Our COVID-19 credit analysis tells us states like New Jersey face relatively high credit pressures compared with states like North Carolina and Texas, which enjoy higher financial resiliency and

economic diversity. Even states like New York—which came into this crisis with far more financial resiliency than states like Illinois—now face tough budget choices. With tax receipts already down 12.4% and state unemployment over 11% and climbing, New York Governor Andrew Cuomo’s enacted budget proposes US$10.1 billion in budget cuts, largely to public schools and state Medicaid health care—two of the largest budget items in most states.1

It’s important to note here that fresh unemployment data and revised state budgets are ongoing and coming fast. State governors and legislative offices are busy analyzing new economic projections and releasing revised estimates of revenue shortfalls. The credit views presented here are as of the published date and are subject to change, especially if more federal funding to states is approved this summer.