Flush revenues allow states to cash in bonds

BY SourceMedia | MUNICIPAL | 09/21/23 02:21 PM EDT By Scott Sowers

Ignoring a hesitance to cut rates at the Fed, recession worries, and a federal shutdown threat, many state and local governments are still flush with revenue resulting in Indiana muni bonds being paid off early.

"We've defeased pretty much every bond that we can at this point," said Zac Jackson, Indiana's budget director, during a panel discussion hosted by The Volcker Alliance and Penn Institute for Urban Research on Thursday that focused on the effects a projected recession would have on state and local governments.

"We're trying to lower our cost of operations going forward." Defeasance allows the issuer to retire a bond early. It's happening in Indiana partially because the state's revenue is up via higher interest earnings, which is normally a minor revenue category.

The Indiana legislature has also accelerated an individual tax cut tax bill that was already on the books dropping the rate to 2.9% from 3.15%. About half the money in the state's general fund comes from a 7% sales tax.

Fitch Ratings has been monitoring states tinkering with tax rates and notes that in 2021 eighteen states made tax policy changes, 31 made changes in 2022 and 24 in 2023. The adjustments so far don't have much effect on credit ratings. "We still consider states able to absorb these changes and we expect them to be responsive to changing budget conditions," said Eric Kim, senior director, Fitch Ratings.

Fitch also clarified its position on the already much-postponed recession prediction. "We expect that growth is going to start slowing in terms of pace by the fourth quarter of this year and then move into a relatively mild recession by historical standards in the first half of next year," said Kim. "I think that the important point here is that we have pushed back that forecast several times."

The rating agency made headlines in early August when it downgraded the country's long-term foreign currency issuer default rating to AA-plus, a move that was mostly shrugged off by the muni world. Fitch sees no connection between the federal downgrade and what's happening at the local level. "We do not make a direct linkage between the sovereign rating and state and local ratings." said Kim.

Torsten Slok, chief economist, Apollo Global Management (APO) commented on a muni market beset by high borrowing costs and a tight money supply. "We have seen the regional banks get into substantial turbulence in the last six months and this has had some consequences for lending," he said. "They're have also been some questions raised about deposits in the regional banking sector but now that looks more stable."

Fitch awarded ratings of AA Stable for New York City and AA+ Stable for San Francisco, two municipalities that have been struggling with shrinking revenue bases caused by the non-return to work. "We think absolutely there are challenges, but we think the cities are also pretty well positioned to manage those," said Kim."

The agency is also not sweating a shutdown. "This is unfortunately a movie we've seen a lot of times," said Kim. "For the most part and for state and local governments, we've not seen significant implications on the credit side and on the fiscal and economic side."

In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible.

Lower-quality debt securities generally offer higher yields, but also involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.