PHOENIX - Political bickering highlighted by a rash of difficult state-level budget negotiations may be creating a new or heightened risk for bondholders, analysts say.

The concerns have arisen in the weeks following a round of budget negotiations that was particularly tough for several states. While is isn't unusual for state lawmakers to work late into their legislative sessions before sending budget bills to their governors, bondholders this year suffered consequences in the form of credit downgrades and widening spreads as Democrats and Republicans refused to compromise and failed to produce budgets that would help to improve or maintain the fiscal health of their states. Illinois lawmakers had to override the governor’s veto to impose a tax increase, and budget crises played out in Pennsylvania, Connecticut, Alaska, Washington, and New Hampshire as well.

Court Street's George Friedlander sees emerging bondholder risk in state politics.
Court Street's George Friedlander sees emerging bondholder risk in state politics.

Illinois last week drew surprise from market watchers by passing its state budget for the current fiscal year, ending a two-year standoff in which no budget was passed.

“For the Land of Lincoln, the legislature passed the budget by overriding Governor Bruce Rauner’s veto; not exactly the way most observers were hoping they would achieve a positive outcome,” Stephen Winterstein, managing director and chief strategist at Wilmington Trust Corp., wrote in a weekly municipal report. “In doing so, the Prairie State may have narrowly dodged a looming downgrade of its general obligation debt by one of the ratings agencies into junk status,” he wrote. “The market seemed to breathe a collective, yet uncomfortable and unconvincing sigh of relief – maybe mistaken for somewhat of a wince – while the S&P Municipal Bond Illinois Index finished the week as the only state in positive territory.”

Many states that need additional revenue sources have faced political resistance in budget negotiations, according to John Mousseau, executive vice president and director of fixed income at Cumberland Advisors.

“No one is willing to bend politically so you get these impasses,” Mousseau said. “States need more pension contributions. They need reductions in the future, and maybe current pension payments.”

For instance, he said Illinois would benefit from a new amendment allowing for sovereignty in making budgetary changes, while New Jersey needs to adjust its state tax codes and average tax rates to boost population instead of decreasing it. New Jersey could increase its revenue through higher gas taxes, as well as incremental tolls on the New Jersey Turnpike and Garden State Parkway, Mousseau suggested. Those revenues, he added, could be securitized and used to make a pension contribution that might increase the states’ debt ratings and decrease their cost of financing.

Meanwhile, New Jersey should also pass a flatter state tax curve to increase revenue and prevent residents from moving elsewhere, Mousseau said. However, a lot of the fixes face too many political hurdles at the state level to become a reality, he said. “Legislatures have their finger in the political air way too much.”

While some analysts said it isn't unusual for budget negotiations to trigger rating action and that this year was an easier budget cycle for many states, others saw a more ominous note in Illinois and in states like Alaska and Washington. Those states' lawmakers had to hold special sessions and flirted with the possibility of government shutdowns before passing budgets. In Alaska, the failure of the legislature to address a large structural budget deficit led to downgrades from both Moody’s Investors Service and S&P Global Ratings.

George Friedlander, managing partner at Court Street Group Research, noted in a recent report that while Illinois paper widened 50-75 basis points during its budget crisis, the only other state that seemed to suffer a similar effect was in Connecticut which saw about a 10 basis point movement. Friedlander told The Bond Buyer that the particularly bad situation in Illinois as well as market conditions might explain that.

“I don't think that other states have deteriorated nearly to the extent that Illinois has, and I think that the shortage of paper in the muni market is keeping most credit spreads tight for now,” he said. “On the other hand, I believe that there is real potential for states with weakened governance to underperform, especially during periods of market weakness or volatility.”

Even though the market impact of budget impasses was limited, Friedlander said his firm is concerned that “new attitudes among state-level lawmakers may be creating a new type of risk for bondholders.”

“Ratings used to be an important answer to the question, ‘how am I doing?’," Friedlander wrote. “Now, the primary polls for the next election (let alone the actual election polls) seem to have passed credit ratings in the minds of many legislators. This is horrible policy, of course, that will exacerbate the infrastructure funding crisis among other things, but it’s what we are living with right now.”

“It is important to note that this is different, and deeper seated, than the age-old question of 'willingness to pay,'” Friedlander said. “It goes all the way to the question of ‘willingness to govern.’”

Friedlander said that along with relatively strengthening revenue bonds, the new risk heightens the need for professionals to handle muni investments, and that some states over time might best be left to professional investors.

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