Stocks may be volatile, but income investors can at least count on some relative calm from their municipal bonds: States’ financials are looking strong – albeit some more so than others, according to research from Morgan Stanley Investment Management. The Wall Street bank recently issued a report titled “State of the States: How Do They Rank?,” categorizing the 50 states and Puerto Rico based on their financial strength. In all, the credit outlook is stable for most states, according to Morgan Stanley, with rainy day fund balances at all-time highs. Generally, municipal bonds come with a lower default risk compared to similarly-rated corporate issuers. That relative safety, plus the exemption muni income enjoys from federal taxes and state and local taxes if the holder lives in the same jurisdiction, results in lower yields. “What you notice is that even as we rank them one to 50, the middle of the pack is very tight, and small changes can move you up a few slots,” said Craig Brandon, co-head of municipals at Morgan Stanley Investment Management. “The health of the states is pretty strong right now.” Factors under consideration in the rankings include debt, adjusted pension and other post-employment benefits as a percentage of gross domestic product, as well as states’ general fund balance as a percentage of revenues and the adjusted pension liability-funded ratio. States in the top five, in order, were Nebraska, South Dakota, Tennessee, South Dakota and Utah. Digging into the details The top-ranked states aren’t necessarily scoring the highest marks in all of the metrics Morgan Stanley used in its analysis. For instance, while debt, adjusted pension and other-post employment benefits only account for 3.1% of North Dakota’s GDP, the state is at the bottom of the list when it comes to its contribution percentages toward pensions to maintain its funded level. Still, the state ranks at the top in terms of its general fund balance as a percentage of its revenues. “That’s a function of North Dakota having a small budget, a ton of money from Covid, and they’re sitting on this huge pot of money,” Brandon said, noting that the state also has a small spending base. Locales at the bottom of Morgan Stanley’s list include New Jersey, Illinois and Puerto Rico. For perspective, debt, adjusted pension and other post-employment benefits account for 29.4% of the Garden State’s GDP, the report found. Those obligations add up to 28.4% of GDP for Illinois, and nearly 59% for Puerto Rico. Takeaways for muni bond investors Though the states in total are in solid shape, certain hurdles loom, including Medicaid spending, which averages about 34% of state budgets. Medicaid is funded by states and the federal government, and it could see a shake-up if the White House and Congressional Republicans curtail funding . “Hospitals are a huge percentage of the muni market,” said Brandon. “If the federal government significantly cuts Medicaid reimbursements, which states are most able to handle that, and which ones will take it out the backs of their hospitals?” These details are factors for sophisticated investors to consider as they shop for individual issues, particularly if they’re dipping into bonds from charter schools, nursing homes and hospitals – and if they’re willing to hunt for muni bonds with less-than-sterling ratings in exchange for higher yields, according to Brandon. That might be more than what most retail investors are bargaining for, especially if they’re just looking for some tax-free income to complement their portfolio. “Individual investors buy triple-A and double-A bonds to clip the coupon,” he said. “If you’re buying debt that’s investment grade, and you’re holding to maturity, you’ll get your money back and you’re happy.”
