State of the States: Who's the weakest link?

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      By Bill Delahunty, CFADirector of Municipal Research, Eaton Vance Management and Carl Thompson, CFASenior Municipal Analyst, Eaton Vance Management

      Boston - Every year, Eaton Vance's municipal bond research team ranks all U.S. states on their creditworthiness in our State of the States report. Based on our analysis through year-end 2018, the credit outlook for most states appears to be stable.

      In aggregate, state revenue was 12.6% ahead of the pre-recession peak on an inflation-adjusted basis1 — enabling many states to maintain structural balance and build reserves known as rainy day funds. The median rainy day balance as a share of general fund expenditures increased from 1.8% in fiscal 2011 to 6.4% in fiscal 2018.2

      We do find, however, that the operating environment has become more challenging. Some states face structural imbalances from unfunded pension obligations, rising liabilities for other post-employment benefits (OPEB), escalating Medicaid costs, limited reserves and stressed budgets.

      Debt loads and unfunded pension burdens

      Many states curtailed borrowing after the Great Recession from 2007 to 2009. Combined with increasing state gross domestic product (GDP), this has resulted in state debt remaining low, at a median 2% of GDP.3 Thanks to economic growth, robust investment returns and pension reforms, the median debt and unfunded pension liability as a share of GDP declined from 8.3% in 2011 to 5.1% in 2018.4

      Other qualitative and quantitative factors to consider

      Of course, debt and unfunded liabilities are just one aspect of municipal creditworthiness. That's why the research team evaluates a number of qualitative and quantitative factors to determine each state's credit quality. On the qualitative side, we consider projected budget shortfalls or surpluses, the historical record of meeting financial projections, pension reform initiatives and proposals to increase revenues or decrease expenses, among other factors.

      Quantitative factors measure the state's financial performance, economy and wealth. Governmental fund liquidity indicates that a state has the flexibility to make payments without short-term borrowing. A growing economy (adjusted for inflation) can lower the unemployment rate and raise median household income. Wealthier states tend to have greater flexibility for raising tax revenues, which can offset fiscal budget pressures.

      Five strongest and weakest states

      • Ranked in descending order, the five strongest U.S. states are Idaho, North Dakota, South Dakota, Wyoming and Tennessee.
      • Ranked in ascending order, the five weakest states and territories are Puerto Rico, Illinois, New Jersey, Kentucky and Connecticut.

      Among highly ranked states, we see common characteristics of timely legislative action, conservative budgeting practices, sizeable reserves, low debt burdens and strong funding of pension and other legacy liabilities.

      When we dig deeper into the weakest states, we find that Illinois, Connecticut and New Jersey have debt loads and unfunded pension burdens above 20% of GDP - much higher than the median of 5.1% across all the states.4

      Connecticut's burdens include a slower economic recovery and very high debt levels compared to other states, but it has improved financially in recent years, with sizeable operating surpluses and increased reserves that strengthen its preparedness for the next economic downturn. Kentucky's poorly funded pensions, pressured financial position and below-average economy drive its low ranking.

      Along with one of the highest tax burdens in the U.S. — limiting its ability to raise additional tax revenue — New Jersey is hindered by structurally unbalanced budgets and rapidly growing pension and debt costs. Illinois continues to contend with the intertwined problems of budget deficits, growing pension liabilities and the need for additional tax increases.

      Puerto Rico remains a significant outlier, with debt, unfunded pension and OPEB liabilities at 90% of GDP — more than double any of the 50 states and dwarfing the median liability-to-GDP ratio at 6.9%.4 And the territory's real annual GDP growth has been negative over the past five years.5

      Bottom line: Beyond the states and territories we discussed here, there are over 40,000 different local general obligation (GO) and essential service credits. In some highly ranked states, certain local issuers may pose credit risks, while in some low-ranking states, other local issuers may exhibit strong credit characteristics. That's why we believe independent, professional credit research is so important when navigating the broad and idiosyncratic municipal bond market.