Do state trifectas lower default risk?

Single-party dominance in a state appears to lead to modest but measurable savings for local governments and lower yields in the secondary municipal bond market.

The impact of a state trifecta on secondary market bond yields is more pronounced when the state has laws that investors perceive as raising default risk, such as allowing unconditional access to municipal bankruptcy.

Those are some of the findings from the paper "State government trifectas and municipal bond pricing," presented Wednesday at the annual Brookings Municipal Finance conference. George Washington University professors Angela Gore and Riddha Basu penned the paper with Amanda Beck from Georgia State University. The authors examined a variety of local government bond prices from 2005 to 2018.

Yield spreads on secondary market local government bonds traded a modest but "economically significant" four to 20 basis points lower when one party won control of the state legislature and governor's seat, the paper said.

An effect on bond prices, though smaller, can also been seen in the primary market, the authors found. "Results demonstrate trifectas significantly reduce primary market bondholder yields," the paper said, with primary market offering yields approximately 2.3 basis points lower.

Overall, the paper said it provides "novel evidence of municipal bond market implications of state-level political party dominance."

As of July 18, there are 23 Republican trifectas, 17 Democratic trifectas, and 10 divided governments where neither party holds trifecta control, according to Ballotpedia. As a result of the 2023 elections, there were 40 trifectas across the country, the site said. That marks more trifectas than at any other point from 1992 to 2022.

Researchers also examined whether state trifectas affected bond prices in states with laws, or "institutions," that investors tend to see as increasing default risk: unfettered access to Chapter 9, the restriction of local tax increases, and allowing direct voter initiatives.

"State trifectas helped offset the higher risks associated with hands-off local bankruptcy policies," said Gore at the conference. "We see that in the other two tests as well," she said. "When you've got a state with high tax restrictiveness over the local [governments], trifectas are unwinding them."

The effect was strongest among states with Democratic control, Gore added.

The paper makes clear that bondholders seem to pay attention to how party control mediates state laws like bankruptcy and local tax restrictions, said Tracy Gordon from the Urban-Brookings Tax Policy Center, who responded to the paper at the conference.

"It's a fantastic paper," Gordon said. It shows that "it's the institutions that matter, and it is more clear when you talk about unified party control that increases the likelihood of the enforcement of the institutions."