Joe Rosenblum (pictured), Neene Jenkins and John Ceffalio
Every state faces challenges when it comes to balancing the books, but not every state is equally effective at tackling them. The responses of California and Illinois to post-2008 difficulties show how different the approaches can be—and how much is at stake.
The period after the Great Recession, with jobs scarce and tax collections plummeting, was tough for most states. California and Illinois were especially hard hit, but only one has succeeded in turning its finances around. The two states’ stories highlight the diversity of the US municipal bond market and how quickly a state’s trajectory can change with effective political leadership.
By 2011, the budget shortfalls of Illinois and California dominated municipal-market headlines. Lower tax revenues and the end of federal stimulus money meant officials had to find ways to balance their budgets with cuts in spending, increases in taxes and fees, and reductions to employee salaries and benefits. Based on market yields at the time, investors seemed skeptical that either state could pull off a U-turn.
Illinois Muddles Along—and Stumbles
Illinois initially took action by raising both personal and corporate tax rates while putting a four-year spending cap in place. But the tax increases were only enough to stabilize finances—not improve them.
And there hasn’t been much more progress since then. In particular, desperately needed pension reform has stalled.
With the income-tax increase scheduled to be phased out beginning in fiscal year 2015, Illinois still faces a $7.5 billion payment backlog, a Medicaid spending gap and higher pension payments (the result of underfunding and increased benefits). An even bigger problem: Illinois’ government consistently seems to be in crisis-management mode—waiting too long to act and losing the public’s confidence in the process. The income-tax increase, for example, took an agonizingly long time.
The state government’s inability to execute decisively leaves a yawning pension funding gap that has increased its borrowing costs and undermined its credit rating. In June 2013, both Fitch Ratings and Moody’s Investors Service downgraded Illinois general-obligation bonds. Standard & Poor’s had already knocked its rating down to A–, making Illinois the lowest-rated state. Residents now pay higher financing costs due to ineffective political leadership.
California Moves to the Head of the Class
California’s outcome was different. Two years ago, it faced a $26 billion budget gap and had run up $35 billion in budgetary borrowing. Even after deep cuts to education, libraries and public parks created a doomsday mood, the budget was still in the red. Today, California has a balanced budget and steadily improving credit ratings.
What happened? Governor Brown worked closely with the state legislature to craft solutions that cut spending and extended temporary tax increases.
But it wasn’t an easy path, especially in the beginning. California tax increases require a two-thirds legislative majority; this requirement had gridlocked Democrats’ efforts to raise taxes. Brown broke the impasse by taking his plans straight to the people—voters in 2012 opted for tax increases rather than further draconian program cuts.
In the end, California’s aggressive path paved the way for a turnaround, and California municipal bonds have performed well. But even when the state was in bad shape, it wasn’t close to defaulting. Neither is Illinois, for that matter. Many state and local governments have faced challenges, but most have sidestepped severe fiscal stress. However, investor perceptions create ominous headlines and hurt bond prices. And lower credit ratings make it more expensive for states to borrow money.
In the end, the municipal bond market’s immensity and diversity are part of its appeal for active managers. It’s always possible to find issuers headed up and others headed down. That presents a lot of opportunity to stand out through fundamental credit research. In our view, knowing when to respond to a state’s troubles by reducing exposure, and when to increase and catch the state on the upswing, is the key to building strong returns.
The views expressed herein do not constitute research, tax advice, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. Past performance of the asset classes discussed in this article does not guarantee future results.
Joe Rosenblum is Director of Municipal Credit Research at AllianceBernstein. Neene Jenkins and John Ceffalio are Municipal Credit Research Analysts, both at AllianceBernstein.