For those wondering why generations of investors choose municipal bonds to help them sleep well at night, California’s budget process may provide some answers.
A few years ago, the state’s budget surpluses reached more than $100 billion. But in the past two fiscal years, the state incurred deficits of $32 billion and $44.9 billion, respectively.
How California did a fiscal U-turn, and then closed those deficits, speaks to the power and flexibility that state governments – a primary issuer of municipal bonds – possess.
Closing revenue gaps
The taxes California relies on for most of its revenues has changed over time, and the state is subject to wild swings in its revenues.
Previously, retail sales and use taxes provided the bulk of its revenue; now, it’s personal income taxes. As the economy and stock market gyrate and affect the wealth of its residents, so goes a major source of California’s revenues.
Last year, revenues were hit by inflation and a weak stock market. But legislators closed the deficit by cutting spending in some areas, delaying spending in others and shifting some expenses to other funds.
In fiscal year 2024, a slowing economy, rising unemployment and a slump in the tech industry eroded revenues.
Further, the state had problems formulating the fiscal 2024 budget after floods caused a seven-month delay in the tax-filing deadline. Actual revenue figures weren’t reported until months after the budget was signed in June 2023.
Recently, legislators passed a balanced budget for fiscal years 2025-2026, cutting spending, raising revenues, drawing on reserves and implementing temporary measures to patch the hole in FY 2024’s budget.
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“While further adjustments may be necessary to align spending with the lower revenue trajectory, Fitch believes this budget allows California to retain strong gap-closing capacity, supporting its ‘AA’/Stable Issuer Default Rating,” Fitch Ratings said in a release.
States have an array of tools
To be sure, financial risks remain. As Fitch pointed out, California may have to take additional measures to make up for potentially lower revenue.
But as we have pointed out (“Strong States Behind the Municipal Bond Market”), states have an array of tools to deal with fiscal turbulence. And healthy states, of course, benefit local issuers, which often depend on state governments for aid.
Not every state experiences roller-coaster revenues as California does. Indeed, taxes and revenue sources vary among states, affording investors a variety of options in the municipal bond market to meet their unique objectives.
Perhaps that helps explain why muni holders sleep soundly – and contentedly.
