Credit Analysis for State vs. Local Issuers

Intermediate | Published: 2025-12-29

Why It Matters

The municipal bond market contains 50,000+ distinct issuers with over 1 million CUSIPs (Source: EMMA). Rating agencies can't evaluate every nuance. Bonds with identical ratings from different issuer types can have vastly different risk profiles. A California general obligation bond and a small Illinois special district bond might both carry an A rating, but their default probabilities, recovery rates, and liquidity characteristics differ substantially. The practical edge: understanding systematic differences between state and local credit fundamentals lets you identify mispriced risk that ratings miss.

The State vs. Local Credit Hierarchy

States: Broad Taxing Power, Lower Default Risk

States have three structural advantages:

Diversified revenue base: Income tax + sales tax + fees + federal transfers
Constitutional balanced budget requirements: 49 of 50 states (Vermont excepted)
Monopoly on their revenue sources: Can raise taxes without competing with higher authorities

Quantified risk: The 10-year cumulative default rate for Moody's-rated state GO bonds is approximately 0.02% (Source: Moody's Municipal Default Studies). This is lower than the overall municipal average of 0.042% because states rarely default.

Local Governments: Concentrated Revenue, Higher Variance

Local issuers face tighter constraints:

Property tax dependence: Often 60-80% of general fund revenue
State-imposed limitations: Tax rate caps, spending limits, debt ceilings
Economic concentration: A factory closure or population exodus hits harder
Competition with overlapping jurisdictions: County, city, school district, special district all taxing the same base

Quantified risk: Local government defaults run 3-5x higher than state defaults in most studies, though still far below corporate rates. Senior living facilities and special districts accounted for 60% of 191 missed payments in 2022 (Source: Moody's).

Key Metrics for State Credit Analysis

Pension and OPEB Funding Ratios

This is where state credit diverges most dramatically.

Funded ratio: (Plan Assets) / (Actuarial Accrued Liability)

Funded Ratio	Interpretation
90%+	Healthy, minimal concern
70-90%	Elevated but manageable
50-70%	Material credit pressure
<50%	Significant risk factor

Why this matters: States with funded ratios below 60% (Illinois, Kentucky, New Jersey historically) face A → A → B rating trajectories as unfunded liabilities consume general fund capacity. Illinois has operated with a funded ratio near 40%, driving a BBB-/Baa3 rating despite being the 5th largest state economy.

The calculation to verify:

Annual Required Contribution Coverage = General Fund Revenue / Annual Pension Contribution

Ratios below 5x suggest pension costs are crowding out other spending. Ratios above 10x indicate pension burdens are manageable.

Rainy Day Fund Reserves

Formula: Reserve Fund Balance / General Fund Expenditures

Benchmarks:

10%+: Strong cushion for revenue shocks
5-10%: Adequate but limited flexibility
<5%: Vulnerable to cyclical downturns

COVID-19 data: States with reserves above 10% maintained ratings through 2020-2021. States with reserves below 5% saw negative outlook assignments. Cities experienced an average 21% revenue decline in 2020 while expenditures increased 17% (Source: COVID-19 Impact Analysis).

Debt Burden Ratios

Net Tax-Supported Debt / Personal Income:

<3%: Low debt burden
3-5%: Moderate
>5%: Elevated, monitor trajectory

Debt Service / General Fund Expenditures:

<5%: Comfortable capacity
5-10%: Moderate, watch for crowding
>10%: Limited flexibility for new issuance

The point is: Debt ratios matter less in isolation than when combined with revenue trends. A state with 6% debt/income but 4% annual revenue growth has more capacity than one with 4% debt/income and flat revenues.

Key Metrics for Local Credit Analysis

Tax Base Concentration

Local credits fail when their tax base collapses. The question is: how concentrated is that base?

Top 10 Taxpayer Concentration:

<25%: Diversified, lower risk
25-40%: Moderate concentration, monitor
>40%: High concentration risk, single-employer dependency

Detroit's collapse: By 2013, Detroit's population had fallen from 1.85 million (1950) to 680,000, property values had cratered, and the tax base couldn't support legacy obligations. ULTGO bondholders received ~75 cents on dollar, while general fund paper holders got as little as 14 cents (Source: Detroit Bankruptcy Case Study).

Overlapping Debt

Local taxpayers often carry debt from multiple jurisdictions: city, county, school district, special district. Credit analysis requires aggregating all claims on the same tax base.

Direct + Overlapping Debt / Assessed Value:

<5%: Low burden
5-10%: Moderate
>10%: Elevated, especially if assessed values are declining

Operating Position

Formula: (Total Revenue - Total Expenditure) / Total Revenue

Interpretation:

Positive: Operating surplus, building reserves
Negative <-3%: Structural deficit, drawing down reserves
Negative >-5%: Unsustainable, credit deterioration likely

San Bernardino's pattern: Property values fell 70%, unemployment reached 22%, and the city filed bankruptcy in 2012. Pension obligation bondholders received 1% recovery (Source: California Cities Case Study).

The State-Local Relationship (Why It Matters)

State Aid as Local Revenue

Local governments depend on state transfers for 30-50% of revenue in education-heavy districts. When states face budget pressure, aid cuts flow downhill.

The causal chain:

State recession → State revenue shortfall → Aid cuts to localities → Local budget stress → Local rating pressure

This transmission mechanism explains why local credit analysis requires understanding the overlying state's fiscal health.

State Intervention Powers

States can intervene in distressed localities through:

Emergency managers: Michigan's approach with Detroit and Flint
Control boards: New York's approach with NYC (1975) and more recently with Puerto Rico
Bankruptcy prohibition: Some states don't authorize Chapter 9 filings

Harrisburg example: When the city voted for Chapter 9 in October 2011, the Pennsylvania legislature prohibited the filing. The bankruptcy petition was dismissed November 23, 2011, and a state receiver was appointed in 2012. Bondholders received better recovery than they would have under Chapter 9 (Source: Harrisburg Case Study).

The durable lesson: State legal frameworks determine local restructuring options. Before investing in stressed local credits, understand whether Chapter 9 is even available.

Sector-Specific Credit Drivers

School Districts

Primary revenue: Property taxes + state aid Key metrics:

Enrollment trends (declining enrollment = declining state aid)
Assessed value per pupil
Teachers union contract obligations
State equalization formulas

Warning sign: Districts with enrollment declining >3% annually face structural revenue pressure regardless of rating.

Hospitals (501(c)(3) Bonds)

Primary revenue: Patient service revenue, heavily influenced by payer mix

Critical metrics:

EBITDA Margin: Target 15-20%
Occupancy Rates: Baseline >65%
Medicaid Dependency: Ideally <30% of revenue
Debt Service Coverage Ratio: Minimum 1.2x, healthy >1.5x

DSCR Formula: (Net Income + Interest + Depreciation + Amortization - Unrealized Gains/Losses) / (Interest + Current Portion LTD)

Why this matters: Hospitals represent the highest-risk sector in municipal credit. Retirement care centers and industrial development bonds account for the highest default rates (Source: Moody's Default Studies).

Utilities (Water, Sewer, Electric)

Primary revenue: User charges Key metrics:

Rate covenant coverage: Most require 1.25x minimum DSCR
Days cash on hand: Target >200 days
Customer concentration: Largest customer <10% of revenue

Jefferson County lesson: The county's $3.14 billion sewer debt led to the largest municipal bankruptcy in U.S. history at the time (2011). However, water and sewer revenue bonds continued paying throughout Detroit's bankruptcy because they were backed by specific revenue pledges, not general funds (Source: Jefferson County Case Study).

Rating Agency Approaches (Know Their Frameworks)

Moody's State Rating Methodology

Four equally weighted factors:

Economy (25%): GDP growth, employment, income levels
Governance (25%): Budget practices, pension management
Finances (25%): Reserves, liquidity, debt burden
Debt (25%): Affordability, structure, contingent liabilities

S&P Local Government Methodology

Five factors with varying weights:

Institutional framework (10%): State-local fiscal relationship
Economy (30%): Tax base, income, employment
Management (20%): Budget practices, reserves
Budgetary flexibility (10%): Revenue-raising capacity
Debt and contingent liabilities (30%): Pension, OPEB, direct debt

The point is: Rating agencies weight factors differently. A issuer strong on economy but weak on management might get different ratings from Moody's vs. S&P. Split ratings are common and meaningful.

Comparative Analysis Framework

State-to-State Comparison Checklist

When comparing two state GO credits:

Funded ratio differential (pension + OPEB)
Reserve fund coverage (rainy day as % of expenditure)
Revenue volatility (income tax % of revenue)
Debt trajectory (growing or declining as % of income)
Economic diversification (top 3 industries as % of GDP)

Local-to-Local Comparison Checklist

When comparing two local credits:

Tax base concentration (top 10 taxpayers)
Population trend (growing, stable, declining)
Overlapping debt burden (total claims on tax base)
State aid dependency (% of revenue from state)
Fund balance trajectory (building or depleting)

Mitigation Checklist

Essential (High ROI)

Compare issuer's funded ratio to state median before purchase
Check population and assessed value trends (5-year minimum)
Calculate overlapping debt for local credits
Verify state's Chapter 9 authorization status

High-Impact (For Concentrated Positions)

Read the Official Statement credit section, not just rating summary
Track annual budget updates on EMMA for material positions
Monitor state aid allocations to dependent local issuers
Compare debt service coverage ratios across similar issuers

Common Investor Mistakes

Mistake 1: Over-Reliance on Credit Ratings

The pattern: Treating ratings as comprehensive indicators. Bonds with the same rating can vary widely in credit quality depending on sector, state relationship, and specific credit drivers.

The fix: Ratings are starting points, not conclusions. Use the metrics above to validate or challenge the rating (Source: Stanford GSB Research).

Mistake 2: Ignoring the State-Local Relationship

The pattern: Analyzing local credits in isolation without understanding state aid dependency or state intervention powers.

The fix: For any local credit with >20% state aid dependency, analyze the state's credit condition as part of your local analysis.

Mistake 3: Extrapolating Recent Trends

The pattern: Assuming current revenue growth or decline continues indefinitely.

The fix: Use 10-year average growth rates for projections. Municipal credit deterioration happens slowly, then suddenly (Detroit lost population for 60 years before bankruptcy).

Detection Signals (Credit Deterioration Warning Signs)

Negative outlook from any major rating agency (often precedes downgrade by 12-24 months)
Fund balance declining for 3+ consecutive years
Pension contributions below actuarially determined amounts (deferring costs)
One-time revenue measures (asset sales, accounting changes) to balance budgets
Population decline accelerating (indicates tax base erosion)
Delayed financial statements (may indicate management capacity issues)

Disclosure Requirements and EMMA Filings
Default Case Studies in the Municipal Market
General Obligation vs. Revenue Bonds

References

Moody's Investors Service. (2024). US Municipal Bond Defaults and Recoveries. (1-year cumulative default rate for Moody's-rated munis: 0.0043%; 10-year cumulative: 0.0420%; average recovery rate: 66% of par)

EMMA - Electronic Municipal Market Access. (2024). (Designated by SEC as official source for municipal securities data since 2009; contains over 1 million CUSIPs from 50,000 distinct issuers)

SIFMA. (2024). U.S. Municipal Bonds Statistics. (Outstanding municipal bonds at year-end 2024: $4.2 trillion; 2024 issuance: $513.6 billion)

Federal Reserve Research. (2021). COVID-19 Impact on Municipal Finances. (Cities experienced average 21% revenue decline in 2020; expenditures increased 17%)