State of the States

Long considered the best issuers in the municipal bond market, states are under a lot of strain. Mounting pension shortfalls and high debt are upping the risk for state muni-bond investors.

by Andrew Bary, Barron’s August 26, 2012

States have long been considered the best group of issuers in the municipal bond market, thanks to modest debt levels and ample taxing power. That's still the case, though many states, including Illinois, Connecticut, New Jersey and Hawaii, are bedeviled by large unfunded pension liabilities stemming from weak investment returns and inadequate state contributions to the plans. Adding to the strain are huge and growing unfunded liabilities for post-retirement health care for state employees.

That strain was brought into sharper focus recently with Berkshire Hathaway's disclosure that it had terminated $8 billion of municipal derivatives contracts. Those contracts were effectively bullish bets on state finances. Berkshire CEO Warren Buffett is bullish no more. The company's $30 billion bond portfolio is light in munis, and Buffett is warning about rising municipal bankruptcies and of the risks of insuring tax-exempt debt. "The stigma probably has been reduced when you get very sizable cities like Stockton and San Bernardino to do it," Buffett told Bloomberg television last month, referring to the bankruptcy of the two California cities. The fiscal pain -- and credit risk -- is more pronounced at the local than state level.

For municipal bond investors, it all boils down to this: The risk of investing in the debt of some of the country's least financially sound states, compared with the most sound, is not always reflected in the price of their bonds.

By the measure we use, which looks at the combined debt and unfunded pension liabilities relative to GDP in each of the 50 states, South Dakota comes out on top. The state has a strong agricultural economy and a low jobless rate of 4.4%, about half the national average. Debt and unfunded pensions add up to just 1% of GDP. Connecticut, which ranks at the bottom of the list, has a combined score of 17%. Yet the bonds in both states are priced alike, at 28 basis points above the 10-year AAA-rated benchmark, which yields around 1.8%. A basis point is one-hundredth of a percentage point.

Granted, the risk of Connecticut -- or any state, for that matter -- defaulting on its debt is small, but investors are not being rewarded for taking any risk at all.

The ratings agencies, which take a state's economic strength, wealth and taxing power into account, show somewhat different results. Moody's Investors Service sets the average credit rating for all 47 states at a strong Aa2; 15 states have triple-A ratings. It doesn't rate South Dakota, Nebraska and Wyoming because they have virtually no debt.

The two states with the lowest credit ratings, Illinois and California, are still at single-A, comfortably within the investment-grade category, though Illinois muni debt is priced dramatically higher than the other 49 states, at 157 basis points above the AAA benchmark.

Puerto Rico is off the charts in every metric.

High-quality 30-year muni bonds carry yields in the 3% to 3.5% range. And here, too, with little differentiation being made among the states, investors can benefit by purchasing debt of the better-run states at similar yields to some of the worst. Many individuals from high-tax states admittedly only buy debt from their own states because out-of-state debt is subject to their state's income taxes. Yet many pros advise some state diversity in holdings, especially if munis make up a large portion of an individual's portfolio.

WHICH STATES LOOK BEST? In addition to South Dakota, Iowa, Tennessee and North Carolina are at the top of the list. (Our ranking is based on analysis from Eaton Vance, a leading manager of municipal funds, that measures state debt and unfunded pension liabilities.) The bottom-ranked states are Connecticut, Illinois, Hawaii and Kentucky.

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