A couple of weeks ago we wrote about “numbers” in the municipal bond markets. On the pessimistic end, we showed trillions of dollars in unfunded state pension liabilities while on the optimistic end we showed a .03% historical default rate on investment grade municipals.
Many states face significant budget stress. While states have already reduced budget gaps by $84 billion, many still face daunting challenges.
So, what options are available?
One solution is simple. States can cut spending and raise revenue. Yes, that means higher taxes and fewer services. States can also borrow at near historically low interest rates. There is a saying in the municipal market “doctors bury their mistakes, municipalities refinance them.”
Delaying payments and using fancy bookkeeping can be helpful. In 2009, California deferred payments to creditors and Illinois delayed payments on some of its obligations. Many states shift costs between fiscal years, borrow from lottery programs and grab funds initially segregated for other uses. These are not solutions. They are methods to paint a rosier picture during difficult times.
Perhaps the biggest long term challenges are unmanageable pension and health care obligations. Given the political implications, many states have been unwilling to restructure these obligations. Perhaps Congress will require states to more accurately project the size of pension liabilities or risk their ability to issue tax-free bonds. The concept of a “defined benefit” plan for state employees may be a thing of the past. Many states are moving toward “defined contribution” plans, similar to private industry.
Will financial stresses lead to defaults by states? Anything is possible. But we believe pandemic defaults are extremely unlikely. If a state were to default, the ability to access the capital markets would be compromised for years to come. In many states, bondholders stand in the front of the creditor line and default would be difficult.
A comprehensive solution will most likely take time and a combination of efforts.