Municipal bond issuers are fiscally prepared for economic weakness

With their collective fiscal health at its strongest in decades, most U.S. states are well-positioned to weather a potential recession, according to Fidelity’s Cormac Cullen.

“Since 2020, state governments have received an influx of COVID-related federal relief, followed by a vigorous rebound in revenue that, in most cases, vastly exceeded estimates and left many states with a historically high reserve,” says Cullen, co-portfolio manager of Fidelity^® Municipal Income Fund (FHIGX).

The fund is a diversified national municipal bond strategy focused on general obligation and revenue-backed municipal securities across the yield curve. In choosing investments for the fund, Cullen and fellow managers Michael Maka and Elizah McLaughlin evaluate creditworthiness on a state-by-state basis.

For fiscal year 2022, 49 states reported general-fund revenue collection that exceeded budget forecasts by a collective 20.5%, says Cullen, citing data from the National Association of State Budget Officers.

“The national total for ‘rainy day’ fund balances hit an all-time high of $134.5 billion in 2022,” he says. “Prior to the 2008 recession, these reserve fund balances peaked at $33.2 billion.”

Cullen explains that states’ fiscal health is significant for municipal bond investors because state debt represents the largest sector (14%) in the $4 trillion municipal bond market. In addition, he says, states are a significant funding source for other municipal issuers, including cities, counties, and school districts, so their fiscal health has broad consequences.

When he assesses the landscape for munis, Cullen is encouraged by strength in the U.S. labor market and in consumer spending, which he says continue to be a tailwind for tax receipts in many states.

Even if growth slows from here, states generally have budgeted conservatively for the current fiscal year, according to Cullen. “Most state budget makers have acknowledged that an economic slowdown could negatively impact state revenue, and that inflation will increase expenses,” he notes.

Moreover, many states have a cushion from the unspent portion of the $195 billion State Fiscal Recovery Fund, says Cullen, adding that projects funded by this program need to be identified by 2024 and spent by the end of 2026. “Of course, it is incumbent upon us to evaluate whether states are appropriately prepared for the pandemic-era federal funding to expire at that time, particularly given other challenges that may lie ahead,” he says.

Cullen also points out that states have significant flexibility to address a revenue slowdown, including spending adjustments, tax increases, job cuts, shifts or delays in programs, and borrowing authority.

Ultimately, as Cullen sees it, he, Maka, and McLaughlin must remain vigilant in their analysis of the fiscal health of individual states, given economic uncertainty and some states’ proposals to enact significant policy changes, including proposed tax cuts or rebates.

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