States continue to struggle through their worst budget crises in recent memory. Most states have seen red ink for the last three years, with total state budget gaps estimated at $96 billion for Fiscal Year 2011 (which started in July) and $72 billion for Fiscal Year 2012. With no end in sight to state budget woes, some bond investors are reasonably starting to worry about default. How likely is it that states will default on their bond obligations? And which states should be of greatest concern?
Information from the municipal-bond markets shows that while some states are still able to borrow at low rates, spreads for California and Illinois indicate that they are considered to be at far greater risk of default.
Just as credit card companies offer the lowest rates to individuals with the best credit histories, investors in the bond market offer the most favorable financing terms to states that are the most creditworthy. We can use the interest rates that investors demand as a way to determine which states are most likely to keep paying the interest on their bonds and ultimately repay the principal.