Municipal Bonds: The State of the States

Credit quality in the muni market likely has peaked, but we believe states' strong rainy-day funds and other attributes will lend stability in the near term.

Two states that account for one-third of the municipal bond market, New York and California, are projecting multi-billion-dollar budget gaps for the upcoming fiscal year. Is it cause for concern?

We don't see this as a major cause for concern, but the muni market is likely past the peak in credit quality for this cycle, which could affect issuers' ability to repay debts. However, most states have built up their reserve levels to record-level highs and have many credit strengths, which lends itself to credit stability in the near term, according to ratings agency Standard and Poor's.

Even though credit quality is showing signs of weakness, some bonds in states with a high income tax rate are yielding less than AAA-rated bonds,1 the highest level of credit quality. This generally shouldn't happen, because bonds with greater credit risk should yield more than bonds with less credit risk. The implication is that most investors, even those in high-tax states, may be able to achieve higher after-tax yields by adding munis from other states instead of sticking with only bonds from their home state.

A primer on state debt

Most states issue bonds to fund specific projects, help with cash-flow planning, or for various other purposes. Like most municipal bonds, state general obligation bonds pay interest that is usually exempt from federal income taxes. If purchased by a taxpayer in the issuer's state, they're often exempt from state income taxes, too. As a result of the tax benefits, they may be an attractive option for high-income earners looking for a relatively stable income source.

Bonds issued by states account for about 13% of the muni market. Nearly half of the bonds in the market, including munis issued by states, are from issuers in five states: California, New York, Texas, Illinois, and Florida. Given the high concentration of the market, it can be difficult for investors outside of those states to find enough issuers with differing credit risks to achieve adequate diversification.

State general obligation bonds make up 13% of all munis and five states account for about 50% of all munis outstanding