State Credit Ratings Reveal Who Is Really Broke

How broke is your state? You could rely on budget reports. But a lot depends on each state’s ability to tax its residents, which is a question of the economy. Instead, ask the bond market: State credit ratings reveal who is really broke and who is not.

For now, all eyes are on Europe and the slow-motion train wreck that is the euro, so it can be tempting to ignore the problems at home. Of course, the federal “fiscal cliff” facing the United States is a huge problem. It is, rightfully, the focus of much of the news cycle.

But let’s break down the union, state by state. We aren’t used to thinking about the 50 U.S. states as separate economies, but they are — at least in the eyes of the credit ratings agencies.

You see, the states are generally required by their own laws to balance the books. (The exception is Vermont.) Sounds great, but as the recent State Budget Crisis Task Force reports, there’s a lot of sneaky accounting going on. Artful dodging by the legislatures masks the true depth of the problem, so state credit ratings reveal a lot.

The trouble runs deep, in part because of rising costs for state-run Medicaid programs. Piled on top are pension and state employee healthcare liabilities built up over decades. The states also face declining tax bases, and they fear renewed cuts in federal aid.

According to the task force report:

States are grappling with unprecedented fiscal crises. Even before the 2008 financial collapse, many states faced long-term structural problems. Many economists believe that in the aftermath of the crisis, the economy will grow sluggishly for years as it works off the excesses of the credit and real estate bubbles and endures slow employment growth. Tax revenues are recovering slowly and remain well below their pre-crisis trends.

All of this is made much clearer by looking at the credit ratings of individual states. The Pew Center on the States news service Stateline recently published a great chart that ranks the states by their credit worthiness from 2001 to today. (Stateline is a nonpartisan, nonprofit news service of the Pew Center on the States that provides daily reporting and analysis on trends in state policy.)

A weak credit rating raises the cost of borrowing for a state and is a strong indicator of that state’s economic prospects going forward.

The “triple-A” rating, the highest from Standard & Poor’s, only goes to 13 states. Four states —  Missouri, North Carolina, Virginia and Utah — have held their AAA credit rating for 46 years or more, quite an achievement.

On the other end of the scale you find Arizona, Kentucky, Michigan, New Jersey, Illinois and, at the very bottom with a A- rating, California.

State credit ratings reveal our true connections

More importantly, no man is an island in these times. If Michigan’s auto business declines, parts makers in neighboring states also suffer, as do retirees clear across the country whose pensions might hold automaker stocks.

The takeaway for investors now is that buying individual state bonds is a tricky business. That strategy will be made all the more difficult by any downward pressure on local economies. Factor in declines in federal flows into the states, virtually a given.

Owning bonds is an important piece of your portfolio, the bedrock of a serious asset allocation strategy and just plain common sense. It remains prudent, however, to diversify your bond risk by using low-cost, well-managed bond index funds and ETFs, and to regularly rebalance your assets in a thoughtful way.