For municipal bond investors, surveying the 50 states is a bit like attending a high school reunion. Some folks are doing great, while Ralphie and Julie really need to check into rehab.
The annual State of the States survey by Conning & Co. shows that, as a whole, state finances are pretty good — just not quite as good as they were doing a year ago.
Aside from the usual suspects (we're looking at you, New Jersey, Pennsylvania and Illinois), most states are certainly in better shape than they were at the end of the Great Recession.
WORRISOME RESERVES
Overall, Conning rates the state of state finances as “stable,” a downgrade from “improving.” Aside from declining revenues in the oil patch, Conning notes that expenditures for primary education, Medicare and pensions are also hurting state finances. Most worrisome: Most states don't have adequate reserves for when recession strikes again.
The good news: Utah, Idaho, North Carolina and Oregon have growing economies and low debt and legacy costs from pensions.
On the flip side, states with big energy industries have been un-pleasantly reminded that commodities are a highly cyclical business. Alaska, for example, gets 19.2% of its state gross do-mestic product from mining activities, and 74.3% of its tax revenue from severance taxes, which are imposed on oil and gas producers. All told, the energy states have seen their revenue fall 2.9% during the most recent 12 months.
The states in the worst shape have mainly gotten to their low state without the help of energy. New Jersey, Pennsylvania and Illinois have high legacy costs and high expenditures.
NOTABLE DECLINES
Of special note are Kansas and Oklahoma, which have dropped precipitously since last year's survey. Kansas was 16th in overall health in 2015; it's in 39th place now. Oklahoma has plunged from 7th place to 36th. “Kansas is a unique story because of political action to dramatically lower tax rates,” said Paul Mansour, managing director and research analyst at Conning. They “haven't had the growth they had hoped for.”
For investors, the decline in state finances has meant a relatively wide spread over Treasuries for lower-rated municipal bonds. A 10-year Treasury note yielded 1.71% on May 11, while a 10-year, A-rated muni yielded 1.89%, or a taxable equivalent yield of 2.63% for someone in the 28% tax bracket. The SPDR Nuveen S&P High-Yield Municipal Bond ETF (HYMB) currently sports a 30-day SEC yield of 3.86%.
PUERTO RICO
Those higher yields come with risk. Puerto Rico, for example, is the poster child of high-yielding municipal junk bonds. The island territory is staring at a massive $1.9 billion payment in July that it will most likely miss, and recently defaulted on most of its $469 million payment that was due May 1. Puerto Rico's potential default of $72 billion of debt dwarfs the largest municipal bankruptcy to date, when Detroit filed for an $18.5 billion Chapter 9 bankruptcy in 2013. New Jersey's Atlantic City is very nearly as poor a credit as Puerto Rico. And Chicago school bonds are only for the truly stout of heart.
Those are the horror stories. In reality, however, municipal defaults are extremely rare: There were just four last year, according to Moody's Investor Service. And, while some states are getting smacked by higher energy prices, bonds from toll roads and airports are getting a boost. More people are driving and flying, increasing revenue available to repay bonds.
Some states, such as California, have rebounded smartly from their Great Recession slumps. “They are blessed with a great many internet and high-tech companies, which pay well,” Mr. Mansour said. “They are kind of overlooking the high personal tax rates and the relatively high cost of doing business there.” California, like many other agricultural states, also benefited from lower oil prices.
What is mildly ominous about the state of the states is that it reflects a general slowing of the economy, in large part because of the slowdown in the energy patch.
And for income-oriented investors, the lesson is the same as always: Don't reach for yield. A high-yielding muni can smack your portfolio as hard as a high-yielding junk bond, although the likelihood of outright default is smaller.
