Beyond Bulls & Bears

Fixed Income

Budget Season

For US states, spring marks budget season, a time to check the ledger board and allocate funds to entities and projects within the state—or cut back where needed. Jennifer Johnston, our Municipal Bond Director of Research, explains what her team has an eye on when it comes to state budgets—and the good news is that, in general, things are looking pretty positive.

For sports enthusiasts, spring marks the NCAA “March Madness” basketball tournament, the Masters Tournament in golf, the opening of the US baseball season, and for those of us in the Northern Hemisphere—the advent of warmer weather. For US states, spring also means budget season. Most states have fiscal year ends of June 30, so the budget process usually starts in January or February, and some even in November or December! For many of the states, the governor will announce his or her proposed budget in January or February. This can serve as a way to begin the legislative process, present the administration’s priorities, and in some cases, float trial balloons to get citizen and legislator feedback.

These proposals are just initial thoughts and can change dramatically by April or May when legislatures start holding budget hearings. The changes can be economic or fiscal in nature and oftentimes, political. Typically, legislatures start holding budget hearings during the April–June period, with ultimate passage ideally completed by June 30. Many states have constitutional or statutory requirements for budget adoption by a specific date, with varying repercussions if deadlines aren’t met.

What We Are Watching for this Budget Season

A key message from states this year regarding their budget outlooks is that things are good, and in some cases, have continued to improve since budget proposals were introduced a few months ago. Surpluses are very common for fiscal year (FY) 2021 and FY2022, driven by federal COVID-19-related aid as well as strong growth in sales taxes and income taxes due to strong employment dynamics. In 2020 and 2021, low interest rates enabled states and other municipal issuers to borrow money cheaply to help refinance more expensive debt or manage cash flows, which relieved some budgetary pressures related to borrowing costs.

We think that the strong financial performance will make it easier for states to agree on spending plans and pass timely budgets. However, there are still challenges and risks we are monitoring closely:

  • While FY21 and FY22 showed continue revenue growth, we expect that to slow over FY23. We would like to see FY23 budget assumptions that are more conservative and assume slower revenue growth.
  • How are surpluses being allocated? Are surpluses being allocated for one-time uses rather than funding ongoing programs that need money every year—the more prudent route? Are they being used to build reserves and/or pay down debt or pension liabilities? The answers to these questions may raise red flags about future budgetary pressures that may emerge due to current budget decisions.
  • How is a particular state addressing inflation? In some cases, inflation assumptions might need to be increased further given the robust inflation data that have come in since preliminary budgets were released a few months ago.
  • Given the strong state revenue performance and surplus results, will other governmental entities that rely on state aid also see positive growth with their recipients?
  • As an example, public school districts are often one of the largest recipients of state aid, along with public universities, transportation and housing. Will the states share their excess with other agencies? We expect this would translate to better overall credit fundamentals through better debt service coverage for many other issuers beyond the states.
  • Many states are discussing tax reductions/holidays or taxpayer rebates. These programs can be credit neutral, but we will read the fine print. Are states also building reserves? Are tax holidays short term? Will the state backfill any spending programs typically paid for with those taxes, including debt service? At this point, we are generally satisfied with the programs being discussed, but we will continue to watch as the budget season progresses.
  • This November, many US governors will be running for re-election. We are assessing whether or not some budget items are being used for short-term political gain vs. longer-term fiscal stability.

Some Examples

California: California continues to generate strong surpluses, and strong revenue growth is also triggering a unique constitutional requirement. To comply, the state will need to reduce taxes, pay tax rebates, increase school spending or allocate excess funds other approved purposes. We are likely to learn more about how it intends to comply when the next budget iteration is released in May, but the governor has been talking about a gas tax holiday or rebates. In our view, the fact the state has excess money to provide a holiday or rebate is a positive. Once the details are released, we’ll be able to understand if it is ultimately positive for the credit.

New York: New York is unique in that its fiscal year end is March 31. It has passed its budget (albeit a week and a half late, which we view as an anomaly) that includes a temporary suspension of the gas tax, a homeowner tax rebate and an acceleration of a scheduled personal income tax rollback. The state’s goal is to reduce the impacts from inflation and share the surplus with residents. At this point it appears the use of the surplus is well-allocated between helping the state’s fiscal position and helping residents.

Illinois: Illinois, which only a few years ago suffered from a two-year budget impasse, passed its budget in early April. This comes after ratings upgrades reflected support from federal aid, strong revenues, and strong fiscal management and budgeting. Illinois is directing its surplus to supplemental pension payments: $1.83 billion in tax relief (on groceries, fuel and property) and a $1 billion deposit to the state’s rainy-day fund. We view these uses of the surplus as prudent and a continued demonstration of the strong fiscal management that led to the recent rating-agency upgrades.

What Are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. 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. 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.

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