State budgets hit a bumpy COVID-19 road—analyzing municipal credit pressures

Franklin Templeton Fixed Income—Municipal Bonds

For most US governors, June typically brings political fireworks when state legislatures hammer out final budgets for the next fiscal year. Given the COVID-19 recession and plummeting tax revenues, quite a few governors face hard budget choices this year. Put simply, governors must apply spending cuts or new taxes in ways that won’t degrade the long-term viability of their economies—the engine that drives public services—or risk squeezing access to municipal bond markets. As bond investors, this paper reviews our recent COVID-19 credit research, explaining why some states face mounting credit pressures from high fixed costs and shallow emergency reserves, whereas other states with more diversified economies and strong financial management should fare better post COVID-19.

In the wake of the COVID-19 pandemic, US governors have grabbed the media spotlight. After issuing lockdown procedures and more recently guidelines on re-opening businesses, public awareness of the role governors play in state economies has risen sharply. It’s nothing new, however, for our muni bond team. Evaluating the willingness of governors to make tough financial decisions is a key factor in our credit research, which gauges bond risks. Whereas some buyers of state-issued bonds might not blink if bond yields are tempting enough, our COVID-19 credit analysis helps ensure we are appropriately compensated for risks in states where governors may have chronically shortchanged budgets and degraded financial resiliency.

With regard to credit risks, it’s important to state upfront that despite the COVID-19 recession, states aren’t heading toward bankruptcy. Under current federal law, states can’t file for bankruptcy—granting authorization would require new legislation at the federal level. That said, we think mounting credit pressures could mean ratings reductions for some states if more federal funding doesn’t materialize from the US Congress this summer. Some states were ill-prepared to weather a normal cyclical downturn, let alone the dramatic economic shock of COVID-19. A downgrade could increase borrowing costs for states already weighed down by pension liabilities and meager rainy-day reserves.

To gauge the credit pressures from COVID-19 (and record low oil prices) that are bearing down on state budgets, our team analyzes four key components, that can impact a state’s financial and economic resiliency. Our research combines quantitative metrics—for example, the diversity of tax revenues, exposure to at-risk sectors like tourism and the size of “rainy day” reserves—and qualitative measures that consider the strength of a governor’s ability to implement hard choices like spending cuts or new taxes.

This paper also features five state summaries – New York, New Jersey, Pennsylvania, California, and Texas.

Upcoming budget battles

As we move into peak budget season—most states’ fiscal years (but not all) end June 30th—we think sparks could fly when the budget rubber hits the COVID-19 road during June negotiations. Budget battles are already notorious for headline risks as state legislatures quarrel out in the open through local news outlets. Given the shock of COVID-19 and prospects of more help from the US Congress, these budget skirmishes are already making national headlines this year.

Although we think further muni bond market volatility is likely this year, we also recognize that many states entered this pandemic with replenished rainy-day reserves, helping governors balance their budgets for 2020 and fiscal year 2021. That said, individual states with higher fixed costs, lower reserves, and more exposure to COVID-19 infections could face ratings downgrades.

As always, our muni team will be sifting through prodigious levels of noise this budget season, with an eye towards steering clear of unnecessary risks that aren’t properly compensated.

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All investments involve risks, including possible loss of principal. Because municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the portfolio’s value may decline. Investments in lower-rated bonds include higher risk of default and loss of principal. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value.