Top of the Morning: States - Steady at the wheel, eyes on the road

Jeannine Lennon · UBS Chief Investment Office

US state credit quality is among the market's strongest; state default risk is very low and outlook stable.

State credit is one of the strongest parts of the roughly $4.5 trillion municipal bond market. Support comes from broad taxing authority, spending control, balanced-budget requirements, substantial reserves and relatively low debt burdens. Surpluses, fund balances and liquidity have eased modestly from recent peaks as one-time federal aid receded and inflation raised costs, but reserves remain above pre-pandemic levels. Strong investment returns have improved retirement system assets and reduced overall liabilities. Because conditions were broadly stable, 49 of 51 states stayed in CIO risk categories one and two, and the sector keeps a stable outlook. The CIO sees the risk of a state default as very low and expects state credit quality to stay sound, which supports munis as a capital preservation opportunity.

“State credit remains one of the strongest parts... of the municipal bond market, and that's supported by broad taxing authority, spending control, balanced budget requirements, substantial reserves and relatively low debt burdens.”at 1:21

Jeannine Lennon · UBS Chief Investment Office

Connecticut and Illinois remain elevated-risk states on debt and pension liabilities, but both are improving.

Connecticut and Illinois stay in CIO risk category three, which signals moderate risk, because of their elevated liabilities, including debt and retirement liabilities. Both still show an improving trend, so the rating holds while the direction of travel is positive.

“These two largely remain in this risk category due to their elevated liabilities, including their debt and retirement liabilities. While they both maintain their CIO risk category three reflecting moderate risk, they both continue showing an improving trend.”at 2:23

Jeannine Lennon · UBS Chief Investment Office

Nevada's CIO risk rating stays at category two despite a quantitative upgrade, pending its delayed audit.

Nevada's quantitative score improved to a one, but the CIO subjectively overrode it and kept Nevada at risk category two. The team is waiting for Nevada's delayed fiscal 2025 audit and will review the updated financials when released, publishing an update if needed.

“Notably while Nevada's quantitative score improved to a one, CIO has subjectively overwrote the score maintaining it as a CIO risk category two while we await its delayed fiscal twenty five audit.”at 2:43

Jeannine Lennon · UBS Chief Investment Office

State credit pressure may rise from volatility, tariffs and FEMA changes, though the sector's foundation stays strong.

States face ongoing economic and market volatility, geopolitical conflicts, tariff changes and restructuring at FEMA, along with federal funding and policy uncertainty. That risk may increase credit pressure. The sector still enters this period with above-average reserves, low debt and a record of timely fiscal adjustments, and states have the tools to right-size their budgets if needed.

“Despite the daily headlines and ongoing risk though, the sector enters this period from a position of strength with above average reserves, low debt, and a demonstrated ability and history of making timely fiscal adjustments when necessary.”at 6:33

Jeannine Lennon · UBS Chief Investment Office

State tax-rate divergence since 2021 weakens revenue flexibility as states absorb rising health and social costs.

Taxes are the largest part of state revenue, and states have diverged on tax policy. 23 states have cut top marginal income tax rates since 2021, while six states and DC have raised them. These choices shape how flexible state revenue is. States are expected to absorb higher health and social service costs in coming years, so aligning revenue policy with rising costs is increasingly important.

“The divergence and tax policies in recent years has been noteworthy as 23 states have cut top marginal income tax rates since 2021 while six states and DC have raised them. These choices shape revenue flexibility.”at 3:39

Jeannine Lennon · UBS Chief Investment Office

New York State's tax collections are surging on Wall Street gains and expected record bonuses.

New York State collected $68.5 billion in tax revenue in the first six months of its fiscal year, $7.3 billion more than projected, according to the state controller. Strong Wall Street performance is driving the surge. The controller also expects bonuses to reach an all-time high, which would boost personal income tax collections.

“New York State's tax collections are surging due to Wall Street's market performance. The state collected $68,500,000,000 in tax revenue in the first six months of its fiscal year or $7,300,000,000 more than projected.”at 4:09

Jeannine Lennon · UBS Chief Investment Office

State spending growth, after 5.7% in 2025, is expected to slow in 2027.

Estimated 2025 state spending rose 5.7% to more than $3.2 trillion, led by health care and transportation increases. Spending is estimated to have exceeded original estimates in fiscal 2026, but growth in expenses is expected to slow in 2027.

“Estimated 2025 spending rose 5.7% to more than 3,200,000,000,000, and that was led by health care and transportation related increases... Spending is estimated to have exceeded original estimates in fiscal twenty six, but growth and expenses are expected to slow in 2027.”at 4:47

Jeannine Lennon · UBS Chief Investment Office

States can cut spending and defer capital projects if revenue falls short, limiting shortfall exposure.

States have strong budgetary safeguards, including disciplined revenue monitoring and a record of timely fiscal adjustments. If revenue comes in below expectations, states can adjust spending and defer capital projects. Their constitutions broadly prioritize debt service, which is a small share of overall budgets, so these tools limit the risk of budget shortfalls.

“Disciplined revenue monitoring and a record of timely fiscal adjustments further limit exposure to budget shortfalls. So if revenue is tracking lower than expected, states can adjust spending and defer capital projects on the expense side as their constitution's broadly prioritized debt service.”at 5:45

Jeannine Lennon · UBS Chief Investment Office

The One Big Beautiful Bill Act shifts healthcare and safety-net costs to states, adding long-term budget pressure.

The One Big Beautiful Bill Act, passed last July, moves more healthcare and safety-net responsibility onto states, which adds long-term pressure on state budgets. Because the reductions are phased in, states have time to prepare. States with weaker reserves, limited revenue flexibility, heavier federal dependence or greater exposure to safety-net programs face more pressure.

“Over the longer term, however, states will need to assess how they respond to the passage of the One Big Beautiful Bill Act from last July as the legislation shifts more healthcare and safety net responsibility to states and that's adding long term pressure.”at 5:12