The Safety of State Bonds: A Historical Perspective

By Marc Joffe

The last state general obligation bond default occurred in 1933. Yet many state GOs yield significantly more than US Treasury bonds, reflecting investor fears of future defaults. While past results are no guarantee of future performance, history does offer investors valuable insights into our present situation.

As Table 1 shows, state and territorial bond defaults were relatively frequent during the 19th century.

Table 1. List of State Bond Defaults.

State	Default	Cure	Source	Notes
Alabama	c. 1870		New York Times (1930)
Arkansas	1/1841	7/1869	English (1996)	Some bonds repudiated in 1884
Arkansas	3/1/1933	1941	KBRA (2011)
Florida	1/1841	2/1842	English (1996)	Territory; Debt repudiated
Florida	c. 1870		Ratchford (1941)
Georgia	c. 1870		New York Times (1930)
Illiniois	1/1842	7/1846	English (1996)
Indiana	7/1841	7/1847	English (1996)
Louisana	2/1843	1844	English (1996)	Some bonds repudiated
Louisiana	3/1/1933	5/20/1933	KBRA (2011)	Due to failure of Hibernia Bank
Maryland	1/1842	1/1848	English (1996)
Michigan	7/1841	7/1849	English (1996)	Some bonds redeemed at 30%
Minnesota	1860		Ratchford (1941)
Mississippi	3/1841	11/1852	English (1996)	Mostly repudiated
Missouri	c. 1870		Smythe (1904)
North Carolina	c. 1870		New York Times (1930)
Pennsylvania	8/1842	2/1845	English (1996)
South Carolina	c. 1870		New York Times (1930)
South Carolina	7/15/1932		KBRA (2011)	No loss of principal or interest; maturing bonds were redeemed with new bonds rather than cash.
Tennessee	c. 1870		Ratchford (1941)
Texas	c. 1930		KBRA (2011)	Interest and principal not remitted to certain state-controlled funds; individual investors do not appear to have been impacted.
Virginia	c. 1870		Ratchford (1941)
West Virginia	c. 1870		New York Times (1930)

Sources:

English, W. B. (1996). Understanding the Costs of Sovereign Default: American State Debts in the 1840's. The American Economic Review, 86, 259-275.

Kroll Bond Rating Agency (2011). An Analysis of Historical Municipal Bond Defaults Lessons Learned – The Past as Prologue.

New York Times. Old Repudiated Debts that Stir the British. August 10, 1930. Page X12.

Ratchford, B. U. (1941). American State Debts. Durham, NC: Duke University Press.

Smythe, R. M. (1904). Obsolete American Securities and Corporations. New York: R. M. Smythe.

Most of the 19th century defaults occurred in two waves: one that followed the Panic of 1837 and the other following the Civil War. The first wave of defaults happened after a number of states made heavy investments in canals and state-chartered banks. In the deflationary years that followed the 1837 financial collapse, eight states and the territory of Florida failed to service their obligations. A recent article by Jeff Hummel provides an excellent summary of this situation, along with references for further reading.

The post-Civil War defaults were concentrated in ravaged Southern states, many of which took on substantial loads of debt under “carpetbagger” controlled governments. The carpetbaggers – northerners who came down south with their possessions wrapped in old carpets – seized control of some state governments, issued bonds and then kept much of the proceeds. When local politicians regained control of state governments, they deemed the carpetbagger-incurred debt as illegitimate and repudiated it.

Since the 19th century, all states with the exception of Vermont have implemented balanced budget requirements and other restrictions on debt issuance. As a result, state bonded indebtedness as a percentage of GDP has remained relatively low, while the national debt has skyrocketed.

During the 20th century, there was only one case in which a state bond default resulted in losses for individual investors: the Arkansas default of 1933. Arkansas got into trouble after assuming a large volume of road bonds issued by local governments during the 1920s. This heavy debt load combined with sharply decreased property tax collections (the result of falling property values during the Depression) rendered the state insolvent.

Many readers will undoubtedly be skeptical of state balanced budget requirements given the many news reports of politicians circumventing these restrictions. While elected officials do employ many gimmicks, they also impose real spending cuts and revenue enhancements when closing budget gaps. The result is some growth in debt burdens, but not nearly enough to trigger a solvency crisis. Professors Daniel Bergstresser and Randolph Cohen provide a detailed discussion of constitutional balanced budget rules, methods used to circumvent them and their overall restraining influence in a recent Harvard Business School paper.

Evaluating a Government’s Debt Burden

A government’s debt burden is often stated in terms of a Debt-to-GDP ratio. This ratio scales debt to the size of the economy, thus providing a more consistent measure across political subdivisions with varying populations and wealth. The Bureau of Economic Analysis reports US GDP by State. This BEA measure is called Gross State Product (or GSP). The Census bureau collects state and local government financial data (including indebtedness) each year, with the most recent data being available for Fiscal 2009. By combining the BEA and Census data set, we can measure Debt/GSP by State, as we do in Table 2.

Table 2. Debt/GSP Ratio By State, 2009

State	Total Debt	Gross State Product	Debt/GSP Ratio
Alabama	8,155,943	166,819,000	4.89%
Alaska	6,589,698	45,861,000	14.37%
Arizona	12,324,879	249,711,000	4.94%
Arkansas	4,135,051	98,795,000	4.19%
California	134,571,934	1,847,048,000	7.29%
Colorado	17,202,374	250,664,000	6.86%
Connecticut	28,394,151	227,550,000	12.48%
Delaware	5,984,645	60,660,000	9.87%
Florida	38,885,422	732,782,000	5.31%
Georgia	13,455,164	394,117,000	3.41%
Hawaii	6,880,242	65,428,000	10.52%
Idaho	3,501,676	53,661,000	6.53%
Illinois	56,962,364	631,970,000	9.01%
Indiana	23,711,889	259,894,000	9.12%
Iowa	6,353,306	136,062,000	4.67%
Kansas	5,857,295	122,544,000	4.78%
Kentucky	13,364,138	155,789,000	8.58%
Louisiana	17,504,772	205,117,000	8.53%
Maine	5,297,276	50,039,000	10.59%
Maryland	23,472,579	285,116,000	8.23%
Massachusetts	74,597,901	360,538,000	20.69%
Michigan	29,591,278	369,671,000	8.00%
Minnesota	10,524,424	258,499,000	4.07%
Mississippi	6,208,639	94,406,000	6.58%
Missouri	19,217,206	237,955,000	8.08%
Montana	4,723,765	34,999,000	13.50%
Nebraska	2,516,775	86,411,000	2.91%
Nevada	4,444,804	125,037,000	3.55%
New Hampshire	8,411,660	59,086,000	14.24%
New Jersey	56,897,866	471,946,000	12.06%
New Mexico	8,001,721	76,871,000	10.41%
New York	122,651,630	1,094,104,000	11.21%
North Carolina	19,910,714	407,032,000	4.89%
North Dakota	1,888,148	31,626,000	5.97%
Ohio	27,949,184	462,015,000	6.05%
Oklahoma	9,855,393	142,388,000	6.92%
Oregon	12,678,820	167,481,000	7.57%
Pennsylvania	41,924,042	546,538,000	7.67%
Rhode Island	9,180,938	47,470,000	19.34%
South Carolina	15,313,021	158,786,000	9.64%
South Dakota	3,626,024	38,255,000	9.48%
Tennessee	4,847,786	243,849,000	1.99%
Texas	30,438,160	1,146,647,000	2.65%
Utah	6,267,888	111,301,000	5.63%
Vermont	3,426,670	24,625,000	13.92%
Virginia	24,301,179	409,732,000	5.93%
Washington	24,603,219	331,639,000	7.42%
West Virginia	6,501,995	61,043,000	10.65%
Wisconsin	20,913,355	239,613,000	8.73%
Wyoming	1,320,852	36,760,000	3.59%
50 State Total	1,045,339,855	13,915,950,000	7.51%

By international standards, these ratios are quite low – well below those of the US federal government and other major Western countries. They also compare favorably to large Canadian provinces such as Quebec and Ontario – which had bonded debt to gross product ratios of 44% and 30% respectively in 2009 (according to public accounts documents filed by each province).

Also, it is worth noting that the Census debt totals include much more than a state’s general obligation bonds. These totals also incorporate revenue bonds, industrial revenue bonds, pollution control bonds, special assessment bonds, certificates of participation (COPs), judgments, mortgages and construction loan notes (CLNs) – which are generally junior to general obligations.

When assessing states and national governments, rating agencies often consider the ratio of interest expense to revenue. This ratio is more useful that Debt/GDP because it also reflects the impact of interest rates and the government’s ability to derive revenue from the economy. Japan, for example, can sustain very high Debt/GDP ratios (above 200% by some measures) because it faces very low interest rates. Governments that have relatively limited ability to extract revenue like Greece (due to tax evasion) and the US federal government (due to difficulty of passing tax increases) may face crises at lower levels of Debt/GDP. American states also face lower ceilings on their Debt/GSP ratios because their ability to raise tax rates is limited by the relative ease of relocating to another state (as opposed to another country).

Table 3 shows Interest Expense to Revenue ratios based on Census data.

Table 3. Interest Expense to Total Revenue, 2009

State	Interest Expense	Revenue	Interest/Revenue Ratio
Alabama	340,732	20,504,479	1.66%
Alaska	310,326	9,001,893	3.45%
Arizona	508,006	23,232,724	2.19%
Arkansas	161,048	12,879,574	1.25%
California	6,220,851	113,389,307	5.49%
Colorado	805,668	10,336,795	7.79%
Connecticut	1,432,900	20,931,946	6.85%
Delaware	284,055	5,787,487	4.91%
Florida	1,480,969	45,602,974	3.25%
Georgia	660,288	33,614,408	1.96%
Hawaii	432,964	6,751,116	6.41%
Idaho	180,803	5,537,466	3.27%
Illinois	2,963,785	40,530,099	7.31%
Indiana	899,488	27,948,706	3.22%
Iowa	252,713	13,207,715	1.91%
Kansas	346,754	11,654,910	2.98%
Kentucky	525,344	18,993,131	2.77%
Louisiana	954,107	23,100,188	4.13%
Maine	268,987	6,468,113	4.16%
Maryland	1,044,928	24,071,623	4.34%
Massachusetts	3,736,377	37,260,774	10.03%
Michigan	1,147,573	47,714,878	2.41%
Minnesota	526,994	22,781,153	2.31%
Mississippi	218,614	14,375,357	1.52%
Missouri	847,712	17,937,884	4.73%
Montana	167,993	4,828,033	3.48%
Nebraska	108,050	7,380,731	1.46%
Nevada	212,010	7,531,884	2.81%
New Hampshire	391,573	5,639,852	6.94%
New Jersey	2,139,595	42,946,396	4.98%
New Mexico	324,507	9,643,066	3.37%
New York	5,505,131	92,112,356	5.98%
North Carolina	637,401	30,150,407	2.11%
North Dakota	146,457	4,372,683	3.35%
Ohio	1,445,927	24,961,252	5.79%
Oklahoma	490,185	17,428,959	2.81%
Oregon	456,106	7,507,145	6.08%
Pennsylvania	1,823,759	38,795,484	4.70%
Rhode Island	437,293	4,710,553	9.28%
South Carolina	780,304	19,897,729	3.92%
South Dakota	135,135	2,436,934	5.55%
Tennessee	236,118	18,750,827	1.26%
Texas	1,242,925	82,053,694	1.51%
Utah	243,708	8,783,428	2.77%
Vermont	164,354	4,559,365	3.60%
Virginia	919,732	26,224,905	3.51%
Washington	1,110,674	24,476,808	4.54%
West Virginia	246,458	11,112,547	2.22%
Wisconsin	1,262,365	8,518,436	14.82%
Wyoming	64,221	4,787,884	1.34%
50 State Total	47,243,967	1,123,226,058	4.21%

These ratios reflect each state’s total revenue – not just its general fund revenue – and its interest expense on all bonds – not just general obligations.

When Arkansas defaulted in 1933, its interest to revenue ratio was about 30% - well above the level in any other state at the time and well above present levels. The only two other defaults during the last century by governments similar to US states in comparable nations (New South Wales, Australia in 1931 and Alberta, Canada in 1936) also occurred after the interest to revenue ratio exceeded 30%.

Applicability to Today

Could a state default with an interest to revenue ratio significantly below 30%?  While any financial result is possible, it is highly unlikely. Default is a political decision in which elected officials balance two considerations: (1) inability to spend money on programs due to debt service expenses versus (2) embarrassment and loss of bond market access by defaulting.

When interest expenses are a relatively low proportion of revenue, defaulting does not make any political sense. Indeed, defaulting makes much less political sense now than it did in the 19th century or during the Great Depression.

Most state debt in the 19th century was held in Europe. In 1933, most Arkansas debt was held by investors in other states - in New York and elsewhere. With the inception of state income taxes and their exclusion of most in-state municipal bond interest, a very large proportion of state bonds are now owned by high income residents. Since the bonds are in the hands of voters and campaign contributors, the choice to default is even more politically suicidal than in was in the 1930s.

Pensions and Retiree Benefits

Fears about current state credit quality center around public employee pensions and other employee benefits.  The size of this problem – from a credit standpoint – is often exaggerated because the unfunded liability is juxtaposed with the state’s annual budget. Since the unfunded liability is payable over many years, this comparison is faulty. Further, unfunded liabilities quoted in the media often apply to an entire pension system, whose costs are only partially borne by the state. For example, the State of California is responsible for only about 36% of the beneficiaries in the CalPERS system (according to page 151 of the CalPERS 2011 Comprehensive Annual Financial Report.

Underfunded state employee pensions are nothing new. The problem was also common in the 1970s and early 1980s – the last period of extended poor stock market performance – and did not produce any general obligation defaults. Statistics published by Alicia Munnell and her colleagues at the Boston College Center for Retirement Research show that pension contributions as a proportion of state budgets have yet to return to the peaks reached thirty years ago.

Unfunded retiree health benefits have also been a constant. While it is true that health care costs have risen substantially in recent decades, much of this extra cost is borne by Medicare.

Conclusion

When considering the risk of a state G.O. bond default, investors should be careful to separate their political views from actionable investment information. Inadequately funded retirement plans and political evasions of balanced budget requirements are bad public policies – worthy of criticism in the court of political opinion. Whether these issues are serious enough to trigger an outright default on principal and interest payments, is a very different question, and one that is best answered through historical research and quantitative analysis.

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Marc Joffe is a consultant with PF2 Securities Evaluations, which recently published an open source Public Sector Credit Framework. In 2011, he researched and co-authored Kroll Bond Rating Agency’s municipal bond study. Prior to that, Marc was a Senior Director at Moody’s Analytics. Marc owns State of California bonds.