Municipal Credit Conditions Have Peaked, but Fundamentals Remain Strong

Monthly state income tax collections sank in April, indicating the municipal market credit cycle has likely peaked. Yet the decline – which follows record high tax collections in the previous April – will, in our view, slow dramatically and can be well managed by most state and local governments that have amassed ample reserves. While security selectivity is critical, we expect a recession and state and local budget cuts to fuel outsize fear, creating attractive investment opportunities.

Income tax collections shrink

Almost all states saw income tax revenue shrink from April 2022, but the contraction was particularly noteworthy in Georgia, Illinois, Massachusetts, New Jersey, New York, and California. A drop in collections was widely anticipated amid a cooling economy and capital markets, yet the actual figures were worse than expected in several states, including California and New York. Both states are now forecasting current-year or out-year budget deficits after enjoying large surpluses in recent years.

Yet it is important to put the recent slump in context. We believe current declines are driven less by a deteriorating economy, and more by a return to normal trends following unsustainable revenue growth in recent years. State revenues surged a record 20% in 2021 followed by nearly 14% growth in real terms early in 2022, with April 2022 collections representing a high-water mark for much of the sector.Footnote1 Figure 1 shows April 2023 collections shifted lower, bringing most states more in line with fiscal year 2019 and 2021 results.

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Illinois, for example, reported that April 2023 personal income tax revenues fell by a record one-third from 2022 to $3.7 billion – still among the strongest months on record. And like most states, it also relies heavily on other revenue sources that continue to perform relatively well, including sales taxes. The state’s total revenue collection of $6.2 billion was the second highest on record after April 2022, despite falling 23% from the previous April’s record high.Footnote2

Robust rainy day funds will help plug FY23 and FY24 budget gaps

Most states are in a strong fiscal position, powered by the robust post-pandemic recovery and unprecedented federal pandemic aid. Budget reserves are at an all-time high. As such, states enter a possible recession better prepared than at any point in recent history, with reserves more than four times levels carried into the global financial crisis or GFC (see Figure 2). Rainy day funds are projected to reach 12% of spending in fiscal 2023 – a stark difference from past years when the median fell as low as 0%. These reserves create a sizable buffer against revenue volatility and will provide states time to enact changes (to revenues or expenditures) to balance their budgets.