State credit quality appears stable for now, but concerns are on horizon

By Karel Citroen

The financial health of the states in the U.S. states has vastly improved from the depths of the pandemic. However, high inflation, rising interest rates, financial market volatility and a potential economic slowdown may create challenging conditions for the economic future of many states.

Conning recently reported on state credit quality in our 2022 State of the States report, and we note that the 2021 economic rebound and unprecedented federal fiscal stimulus have been a boon to states’ finances. We maintain a stable outlook on credit quality but are keeping a watchful eye for possible economic downturns as the level of support states enjoyed during the pandemic may not be as robust in the future.

Why municipal bonds?

States are large issuers of municipal debt and municipal securities’ relatively high credit quality is important to many investors such as insurance companies. Municipal securities offer opportunities for diversification by region and away from securities prevalent in many insurer portfolios, such as corporate and U.S. government debt. Municipal securities often offer higher yields than corporate debt of similar quality and duration and, particularly with taxable deals, will typically have a longer duration and a lower history of defaults than corporates.

State of the States: Stable outlook

Conning analyzes 13 metrics indicative of state credit health in our annual State of the States report. The strong economic recovery in 2021 drove annual tax-revenue collections up 22%, but some states rebounded from the pandemic more quickly than others. Some trends continued, such as states in the West and Mountain regions outperforming as they earned five of our top 10 rankings. However, in our 2022 report, Florida gained the top overall spot, with New Hampshire third and Texas fifth.

The lowest-ranked states: Hawaii ranked lowest in our 2021 report, but in our 2022 report it improved by 11 places. Meanwhile, Louisiana fell one position and replaced Hawaii in last place. The five lowest-ranked states (Maryland, West Virginia, Mississippi and Kentucky are the other four) suffered from issues such as weak housing-price changes relative to other states low reserves, high debt levels, weak gross domestic product and poor personal income performance.
Tax-revenue recovery: On the plus side of our metrics, Alaska had the best tax-revenue growth, benefitting from the recovery in oil prices. States relying on leisure, travel and energy for tax revenues did especially well.
Employment growth: States with no personal income tax such as Florida, Texas and Washington saw increases in their labor force and employment numbers. However, California, which has one of the highest personal income tax rates, also grew employment, likely due to its strong economic recovery.
GDP and personal income: Tennessee and New Hampshire posted the strongest growth percentage in GDP year over year while Massachusetts and New York maintained their top positions in GDP per capita. Idaho ranked first in both population growth and personal income, with South Dakota and Florida rounding out the top three for personal income growth.
Population trends: Housing markets were especially strong in Arizona and Utah, benefitting from migration out of the Northeast and Midwest. States with the largest metropolitan areas, such as New York, California, Illinois, Texas and Washington, scored well in terms of GDP per capita, which measures a state’s efficient use of its population.
The top state – Florida: Florida, the report’s overall top-ranked state, has both a large population and a large GDP but is in the bottom third of GDP per capita. For a population that is the third largest in the country, Florida is not nearly as efficient as states like California and New York at producing goods and services, although that could be due to its large retiree population. Florida also joined the top five in the housing price index. Although Florida has long been a popular destination for retirees given its climate (both weather and tax) it may now also be a haven for those who can work from anywhere.

Looking ahead

The extraordinary state financial windfalls of FY21 are not expected to last, a potential challenge for states already in poorer financial shape. The correction in equity markets should push pension funding levels down and future contributions up. For a state like Illinois, projected to use up most of its FY21 reserves to balance its FY22 budget, this could pose a problem for future years. New Jersey and Rhode Island also have very thin reserves compared to their budgets. Structural imbalances will likely lead to lower reserves and less recession preparedness.

As Conning looks ahead, our focus will be on what the new work-from-home dynamics mean for tax collections and what states will do with surpluses, especially with increased financial market volatility and rising concerns of a U.S. recession in 2023.