States anchor muni portfolios as credit ballast despite rising budget, economic and policy pressures

As a core sector of the municipal bond market, states possess unique credit features and budgetary tools that make them appealing to investors at a time of expanding policy uncertainty and signs of emerging credit pressures — circumstances that are requiring the states to shoulder more of the funding burden.

While some of these elements are widely considered throughout the credit evaluation process, other features are less intuitive and perhaps even get overlooked given a lack of familiarity with their positive attributes. 

Overall, states represent a stable and reliable investment.

It is advisable to include these issuers in a quality-centric portfolio as a way to capture credit ballast, portfolio liquidity, and diversification, with the investment thesis more about value and spreads and less about gauging default risk.

A broad mix of personal income taxes, sales taxes and federal transfers have historically provided the main revenue sources for states, with the largest expenditures made for education, Medicaid and other social programs.

Across the public finance community, states typically represent fertile ground for broad stakeholder surveillance and analysis given their active market participation and multi-layered implications for municipal credit.

From evolving policy and judicial shifts in Washington, D.C., to the vagaries of individual state budgetary cycles, states often find themselves in a position that challenges their own resources, commitment to their capital plans, and political will. Nevertheless, for about 100 years now (since Arkansas defaulted in 1933), states have not compromised on their willingness to pay full and timely debt service on their general obligation bonds.

The significance of the wide-ranging powers vested in the states is clearly visible when considering the impact from federal tariff policy as well as the record federal government shutdown, both having unmeasurable consequences upon gross domestic product/gross state product for now.

Clearly, many states will have to make budgetary adjustments and amend their capital plans and discretionary funding programs as slower economic growth, underscored by tepid employment activity, will undoubtedly impact revenue performance and strain financial operations. According to Moody’s Analytics Chief Economist Mark Zandi, 22 states and the District of Columbia are either in recession or at high risk of entering one. 

Debt to GDP for the states is significantly lower than that of the federal government and most sovereigns, even if unfunded pension liabilities are included.

According to S&P Global, the median U.S. state net direct debt as a percentage of real GSP was 1.8% in fiscal year 2024. The Federal Reserve Bank of St. Louis reports total federal public debt as a percentage of GDP at 118.8% for the second quarter of 2025. The data suggests that states can well afford their long-term liabilities, with the ability to do so improving. 

Moody’s cites higher interest rates as the primary cause of recent declines in adjusted net pension liabilities, the largest long-term liability for most states.

Total net tax-supported debt, the second-largest liability for most states, declined slightly and reflects a degree of leverage austerity.

Moody’s further notes that other post-employment benefits (OPEBs) were relatively small compared with pension liabilities in FY 2024. However, we can expect potential upward pressure on pension liabilities, with possible declines in funded ratios, given shifting interest rates and the uncertainty of future equity market performance. 

Nevertheless, the states’ strong quality bias is heavily supported by their substantive flexibility to adjust revenues, given high levels of financial resources (including ample liquidity and internal reserves), strong frameworks for the payment of debt service, conservative debt structures, activist pension reform, and broad economic diversification.

State credit ratings provide the most visible illustration of the overall high-quality nature of the sector.

Most, but not all of the states, issue GOs to finance capital projects, and those that do carry a GO rating based upon their full faith, credit and taxing power, subject to state-specific legal and statutory provisions as well as U.S. constitutional limitations, display at least one prime quality rating, with the exception of Illinois, which has A-category ratings. 

Eleven states are rated triple-A by all assigning rating agencies. Certain states are precluded from issuing GO debt yet may issue bonds subject to legislative appropriation or certain types of revenue bonds, including double-barrel bonds. In certain states, the financing burden may be disproportionately shifted to local jurisdictions. 

Throughout the COVID-19 lockdowns and beyond, states demonstrated their commitment to tight fiscal and debt management practices, even after the stimulus spigot was shut off and lending under the Federal Reserve Board’s Municipal Liquidity Facility ceased operations. Three prime examples of such efforts are seen with GO rating upgrades for New Jersey and Illinois and an outlook revision to positive for Louisiana. 

Let’s recall that prior to the 2008/09 financial crisis, states were generally ill-prepared from a reserve position to optimize budgetary flexibility. According to the National Association of State Budget Officers’ (NASBO) Spring 2025 Fiscal Survey of the States, the median rainy-day fund balance as a percentage of expenditures was 4.8% and 2.6% in FYs 2008 and 2009 respectively. In FY 2025, this metric significantly improved to an estimated 12.8%.

In its Fall 2025 Fiscal Survey of the States, NASBO reported most states maintained or raised their nominal rainy-day fund balances in FY 2025 and expect the same in FY 2026. Although the median rainy-day fund balance as a percentage of expenditures moved lower in FY 2025 due to general fund spending outpacing reserves, this ratio is projected to rise marginally in FY 2026. 

Further, NASBO shows total balances (rainy-day funds plus general fund ending balances) continuing to fall in FY 2025, with expectations for additional decreases in FY 2026 as states spend down prior year unanticipated surpluses that have accumulated in their general funds, a budgetary practice which is considered routine as a way to fund various projects. 

States have clearly learned the valuable lessons taught during the crisis by systematically building reserve balances over the course of 16 years and displaying stronger credit footing with expanded liquidity in a post-pandemic environment. Nevertheless, although these balances provide for ample flexibility, there is reason to believe that many states will need to adopt even more meaningful fiscal austerity programs or else risk significant draws to their reserves. 

In many states, the payment of GO debt service is prioritized by statute or constitutional provisions. Every state except Vermont is constitutionally required to have a balanced budget and all 50 states are prevented from filing for bankruptcy under the Municipal Bankruptcy Act of 1937.

Most states are bound by debt limitations with GO bond authorizations requiring voter approval. States generally rely on effective cash management tools and the ability to drive emergency appropriations to ensure continued debt service when necessary. 

This does not mean to say, however, that fiscal and operational challenges do not exist.

After 135 days from the start of the 2025-2026 fiscal year, Gov. Josh Shapiro of Pennsylvania signed a $50.1 billion budget into law following its passage by a divided legislature.

S&P swiftly followed with an outlook change from positive to stable, with its A-plus rating reflecting a history of late budget adoption as well as uncertainty surrounding political will that forced various school districts to access the short-term note market during the impasse. 

While left intact during the current cycle, future budgetary deliberations will be closely watched for any draws on the state’s rainy-day fund. Despite these challenges, however, there are provisions in Pennsylvania state statutes as well as in covenants with bondholders to ensure full and timely debt service payment.  

Maryland, with Aa1/AAA/AAA ratings, is also on the radar screen for possible use of reserves for balancing future state budgets, yet debt service on its GO bonds is ensured through active review and oversight by the Division of Debt Management and the Capital Debt Affordability Committee, strong bondholder rights and remedies, and the structural integrity of the Annuity Bond Fund, the principal fund used to pay principal and interest. 

Structural deficiencies in California’s budget have revealed the fourth consecutive year of a budget deficit in the state’s 2026-27 fiscal year, and prospects for even deeper shortfalls in subsequent fiscal years.

Although California needs to address its forecasting challenges and the ongoing use of non-recurring budgetary fixes — while contending with the burden of higher spending on education under Proposition 98 and elevated reserve allocations mandated by Proposition 2 — the state is constitutionally mandated to pay for GO debt service, second only to required payments on public K-12 school systems and state higher education.

Furthermore, a continuous appropriation to pay state GO bonds obviates annual legislative action.   

Overall, states have employed a number of strategies and solutions to address budgetary issues.

Many have cut expenses and services, pursued systematic layoffs, shifted financial burdens to local jurisdictions, mounted pension reform, raised revenue when appropriate and where permitted, reduced the use of one-shot budgetary fixes, employed more conservative debt management practices, and utilized cash management strategies.

These activities have assisted in timely budget adoption, greater evidence of structural balance with fewer intra-FY adjustments and renewed allocations to reserve funds.