- We expect an increased divergence in state credit quality in the coming years, compared with what has been seen over the past two decades.
- While the overall state sector remains robust, we believe notable credit distinctions are beginning to materialize among several weaker states.
- Investors should be aware of this divergence and seek to be appropriately compensated for investing in states of varied creditworthiness.
State tax revenues typically exhibit greater economic sensitivity than local governments due to greater reliance on income taxes. Since the end of the Great Recession, states have seen above average annual tax revenue growth, largely driven by robust equity market gains that have generated strong capital gains taxes. A number of states have managed such growth with exceptional prudence — states we deem to be fiscal leaders — and are now in the enviable position of debating what to do with newfound budget surpluses. In particular, two states stand out: California, which was being compared to Greece just a few years ago, and Michigan, which has shown significant fiscal improvement in the face of much-maligned local government credit weakness.
Conversely, there are the states that have squandered the unusually high growth in tax revenue by delaying making the difficult decisions required to rectify structurally imbalanced budgets — states we call fiscal laggards. The high rate of tax revenue growth allowed these states to cover up budgetary imbalances. However, as tax revenue growth has slowed and begun to normalize, structural deficits have begun pressuring fiscal 2014 results and 2015 budgets. Moreover, the states that continue to struggle to balance their budgets five years after the recession are poorly positioned for the next inevitable economic down cycle. Many may be surprised to see Kansas on the laggards list, seeing as it participates in a central plains region that has shown economic resilience throughout the downturn. However, Kansas has a history of relying on non-recurring budget strategies to balance operations, has routinely underfunded its annual pension contributions and is in the process of phasing out its income tax by 2018 — making it largely dependent on economically sensitive excise and severance tax collections.
When comparing fiscal leaders and laggards, we see an elevated risk of broader divergence among state credit quality in future years relative to what we have seen over the past two decades. A few examples of states on both sides of the great divide include1:
|Fiscal Leaders||Fiscal Laggards|
1 Please note that this table represents a sample list.
State sector credit quality is generally robust and has improved significantly since the recession. Where fiscal improvements have occurred amidst the recession and subsequent recovery, definitive action and fiscal fortitude have been at the forefront. Commonalities among fiscal leaders include a willingness to make difficult decisions to realign spending with recurring and reliable tax revenues, a history of full pension payments and a utilization of tax revenue gains to bolster financial reserves. On the other hand, commonalities among fiscal laggards include the chronic use of non-recurring budget fixes, a lack of full pension payments and an inability to adequately rebuild depleted reserves.
Columbia Management maintains that, while not all states are equal, the sector remains one of the strongest in the municipal market, given states’ sovereign powers, vast financial flexibility and large, diverse economies. As such, we do not believe certain states should be avoided outright. Rather, investors should seek adequate yield compensation for those states that may end up on the wrong side of the divide in future years. In the coming months, with austerity fatigue setting in and various gubernatorial elections on the horizon, state governors and legislatures will hammer out fiscal 2015 budgets. It is becoming increasingly important to monitor the various fiscal choices that states make, as the budgetary decisions of today can hasten or hinder the negative consequences of tomorrow.
The views expressed are as of June 2014, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described herein may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
There are risks associated with an investment in a municipal bond fund, including credit risk, interest rate risk, prepayment and extension risk, and geographic concentration risk. See the Fund’s prospectus for information on these and other risks associated with the Fund. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer-term securities.
Income from tax-exempt funds may be subject to state and local taxes and a portion of income may be subject to the federal and/or state alternative minimum tax for certain investors. Federal and state income tax rules will apply to any capital gain distributions and any gains or losses on sales.
Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution, and involve investment risks including possible loss of principal and fluctuation in value.
Columbia Funds are distributed by Columbia Management Investment Distributors, Inc., member FINRA and managed by Columbia Management Investment Advisers, LLC.