One of the prominent municipal bond themes over the past few years relates to how governments have been responding to the economic downturn. While this theme also touches upon Washington's ongoing fiscal drama, it underscores a widening segmentation among states that have taken challenging steps to address their long-term issues and those that have delayed making difficult decisions.

In the aftermath of the financial crisis, California seemed to epitomize the deterioration in state finances. With political stalemates impeding its budgetary process, the state was forced to rely on IOUs for some of its spending needs and in 2011 it projected a budget deficit of up to $27 billion. The issues contributing to these imbalances required structural reform, which is often difficult when it requires political solutions to long-term revenue and spending decisions.¹ Yet, the recent upgrade of California's credit rating by Standard & Poor's, from 'A-' to 'A,' indicates that the state has successfully initiated some important changes.

A major change in California occurred last November when voters approved higher sales and income taxes. Without the additional revenues provided by the tax increase, the continued strain on California's finances could have led to significant budget cuts. And these cuts would have been unlikely to produce such immediate, positive results in moving towards greater budget stability.

While the tax increase is relatively new, there have been additional reforms over the past couple of years that have streamlined California's governing process. For example, approving a budget should become easier now that only a legislative majority is needed for passage, rather than the prior rule that required an approval of two-thirds of the legislature.

Although some wealthy California residents have expressed displeasure at the increase in income taxes, it is an important component in the state's efforts to balance its budget and project a surplus by 2017. Another important aspect of the tax increase is the designated use of proceeds that directs the new revenue to pay existing debt of about $33.5 billion in deferred payments and various loans.² If the state successfully pays these debts, without diverting revenue to various spending projects, the increased financial flexibility could allow the state to effectively tackle other long-term issues.

Spending limits also have been a big part of California's recent progress, as its spending levels are back to where they were in 2007. And recent spending projections for fiscal 2014 are more than 15% below estimates made in 2011.³

If there is a flip side to California's situation, it is on display in Illinois. Although it will be years before states with pension deficits will need to pay out liabilities, most have recognized that they need to take immediate steps to address these anticipated gaps. Many states are moving new employees to partially defined contribution programs, rather than just defined benefit plans. Yet, Illinois has not taken that step. Other moves that states have taken include increasing the eligible retirement age or reducing cost of living increases. But Illinois has not adopted these steps either.

In addition, Illinois has a backlog of unpaid bills, and it continues to struggle finding ways to balance its budget. The combination of these issues led Standard & Poor's to recently downgrade the state's credit rating, from 'A' to 'A-.'

In terms of pension-funding levels, Illinois's plan has declined, from 43.4% in 2011 to an estimated 39% in its 2013 fiscal year.⁴ This is the lowest ratio for any state, and the prospects for a near-term reversal appear to be dim considering how the state has dragged its feet over the past few years. Moreover, in 2015, Illinois has a scheduled reduction in corporate and personal income taxes.

Standard & Poor's negative ratings outlook on Illinois suggests that another downgrade, to 'BBB+,' is possible. While this credit rating would be unusually low for a U.S. state, Illinois should remain in the investment-grade range. This underscores that the potential risk is from further downgrades, rather than an actual default. Indeed, similar to most other states, Illinois has made debt service on general obligation⁵ issues a legal priority above most of its other spending obligations.

Municipal pension deficits are usually considered to be long-term issues, but the ongoing impasse in Illinois, along with its other budgetary issues, has had a near-term effect. The state postponed its first scheduled bond offering of 2013 after the downgrade amid indications that it could not attain a desirable borrowing rate. Illinois suggested that it would likely return to the market once investors had an opportunity to fully digest the downgrade's implications. Despite the poor track record of the state's lawmakers to make difficult decisions, the delay could also give them a chance to pass recently introduced pension legislation.

From an investment perspective, holding general obligation debt from California or Illinois will depend on a strategy's mandated ability to take credit risk and diversify its investments. As long as the outlook is not for a default, there can be a place for each investment opportunity at the right price.

Given the recent news for each state, California bonds currently trade at lower yields than Illinois bonds, so investors need to evaluate how wide that yield spread should be. Also, they should establish expectations regarding these credits to develop an idea of expected returns.

The deepening contrast between the credit profiles of California and Illinois demonstrates how budget management can affect municipal credit quality regardless of the economy's overall performance. As a result, ongoing credit analysis remains an important part of identifying which issuers face deteriorating conditions and which may benefit from taking the initiative to address their long-term issues. And these latter states, such as California, along with some of the states of higher credit quality could provide constructive ideas for politicians immersed in Washington's ongoing fiscal drama.