(MoneyWatch) The fact that many states are facing large budget deficits may not be news, but states' responses are now being graded by the markets. Specifically, New York, Illinois and California -- three of the largest offenders -- have seen the markets and ratings agencies react in very different manners based on their actions (or inactions, as the case may be). Let's see how these states have fared.
Standard & Poor's changed its outlook on the general obligation debt of New York to positive from stable while affirming the AA rating on the state. The rating agency cited the passage of a state budget that moves the state toward structural stability. The budgets reflect restrained spending on costly government programs, including Medicaid and school aid. The new Tier VI pension plan for public employees is also credited in part, something the state's large unions overwhelmingly opposed. The state is now faced with a budget gap of $3.5 billion gap for 2013, much smaller than the projected $14 billion gap forecast just a year earlier.
While the state's actual credit rating hasn't changed, the move provides investors with a bit more confidence in buying general obligation bonds, while likely providing the state with some interest savings. New York's 10-year general obligation bonds are now yielding only about 0.2 percent more than similar AAA-rated bonds. If the fiscal trend continues for at least another two years, Standard & Poor's could raise the rating one notch.
Unfortunately, Illinois is another story. Standard & Poor's downgraded the general obligation rating of the state of Illinois to A from A+ and maintained a negative outlook due to budget uncertainty. The news affects $27.5 billion of outstanding general obligation debt.
The downgrade was the result of the legislature's inability to address the states' debt-ridden public employee pension system, which now has an estimated funded rate of 43 percent, or $83 billion. It's estimated that without action that figure will increase to $93 billion by next summer.
The size of the problem is why Illinois has been called "the Greece next door." Unless the legislature is prepared to address the unfunded pension issue, it seems doomed to fall into a death spiral. Illinois residents and businesses are already heavily taxed, and people worry that a massive "temporary" tax increase -- 67 percent on individuals, 46 percent on employers -- scheduled to expire in 2014 may be permanent. The bottom line is that Illinois is now facing the consequences of its actions -- the bill is coming due and it will be unable to continue to kick the can down the road.
The risks of Illinois general obligation bonds are reflected in yields. The state's10-year bonds are yielding almost 1.5 percent more than similar AAA-rated bonds. That's about 0.8 percent higher than even California's bonds. While Illinois bonds are certainly carrying relatively attractive yields, it's worth remembering that it takes an awful lot of interest to make up for unpaid principal. And given that the main role of fixed income is to dampen the risk of the overall portfolio to an acceptable level, it's simply not prudent to invest in the general obligations of the state of Illinois.
The news was somewhat better for California. Governor Jerry Brown and state lawmakers recently reached an agreement on some pension reforms for future state and local employees in California. Reforms included capping pension salaries, increasing employee contributions, boosting the retirement age, and creating rules that will limit pension spiking tactics. Unfortunately, a number of important proposals that Brown made earlier this year weren't included in the reform, such as moving new employees to a hybrid defined contribution/defined benefit plan. CalPERS, the agency that manages public pension and other benefits for the state, estimates the savings could be $40 billion to $60 billion over 30 years.
Having cleared both the U.S. House and Senate, Brown signed the bill Wednesday.
The yields on California's general obligation bonds look attractive. The 10-year is yielding about 0.7 percent more than similar AAA-rated bonds, much less than the 1.8 percent incremental yield on Illinois bonds with a similar rating. The high tax rate for California residents creates high demand for its obligations. Given the state's inability to completely address its problems, it seems prudent to avoid California general obligation debt, even considering the relatively attractive yields and the tax advantage for residents. However, if you're willing to accept the risks, you should limit the holdings to the short term, say three years or less. You should also limit the amount of holdings to a relatively small portion of your portfolio.
Image courtesy of 401(k) 2012