State of the States with Conning’s Karel Citroen

Stewart: Welcome to another edition of the podcast. I’m Stewart Foley. I’ll be your host. Today’s topic is a very good one for almost any insurance company, municipal bonds. Municipal bonds make up about 10% of all insurance holdings, but significantly higher for P&C. And we’re joined today by Karel Citroen, Managing Director and Head of Municipal Credit Research at Conning. Karel, thanks for taking the time.

Karel: Thanks for having me.

Stewart: We’re going to start this one like we start them all. What was your hometown, your first job, not the fancy one, and a fun fact?

Karel: I grew up in Amsterdam, the Netherlands. My first job would’ve probably been a babysitter and a fun fact about me is that I am a somewhat competitive cyclist here in the state of Connecticut.

Stewart: Oh wow. I was cycling this morning.

Karel: Very good.

Stewart: I’m such a terrible cyclist, but I love it. It’s great. I’d love to talk to you more about this offline.

Karel: Will do.

Stewart: That’s so cool. I used to live in Connecticut not far from, I used to live in West Hartford and that is such a beautiful area to ride. I mean, just amazing.

Karel: Yeah, it’s very pretty here.

Stewart: So Conning puts out this thing every year called the State of the States report, and it’s on our website now. It’s on your website now, as well, and is an outstanding piece of research. Very comprehensive. Can you talk a little bit about what goes into putting it together and what’s its purpose?

Karel: Yes. We as a company have published a State of the States for well over a decade. We look at several credit indicators. At this point, we’re using about 13 of them and we average them to come up with a score and then we ranked the states with 1 being the highest and 50 being the lowest. The metrics that I mentioned, they kind of capture the state’s financial wellbeing, like balance sheet metrics and the state of their economy. So meaning the economic performance, its business climate and then we look at certain socioeconomic factors as well, like population changes. Now, the purpose of it is that it’s a ranking system, so we are ranking the states relative to one another. This means that the lower-ranking states don’t necessarily have to be poor credit quality states. It’s just that we’re trying to rank the states vis-a-vis each other. And so it also allows us year over year to identify states that are doing better versus the other states and some that are performing worse relative to the other states.

Stewart: This topic is near and dear to my heart. I’m a former Municipal Treasurer of the City of Columbia, Missouri. Love municipal bonds, just love the stability. One of the things that struck me about this report is that you’ve changed your outlook on state credit quality to declining from stable. What drove that decision?

Karel: Yes, we had a stable outlook on credit quality for the last couple of years following the onset of the pandemic. At this point where we are in the economic cycle, we do believe that the actual results coming in for the fiscal year 2023, which for most states will end in about 10 days actually at the end of June, those results we anticipate will be weaker year-over-year. Now you might still see growth but much lower growth rates than we had seen in the prior couple of years. And we do also think that the forecast for fiscal 2024 will be lower as well. So either we might see a decline in certain parts of their tax revenue collections or at the minimum lower growth rates.

Now, I do want to point out that, generally speaking, states are still in a very good position to weather such a slowdown. Balance sheets are strong with debt levels having improved and reserves being at all-time high levels. I mentioned debt levels. We have definitely observed that states have put in much more towards their pension plans and their other post-employment contributions have risen. So those are all good.

On the flip side, as I mentioned, I do think that tax revenue growth will come down. We had seen a positive impact of inflation, which drove sales taxes higher. That impact now that inflation is coming down is also going to be mitigated somewhat. And then lastly, the thing I wanted to point out is that some states wealth conditions were very strong the last couple of years have used that as a driver to lower tax rates. We do wonder if those states are at risk more than others. And so that all combined has driven us to assign the declining outlook.

Stewart: So was there anything in this year’s report that surprised you? For example, anything that stood out in particular states, top or bottom. I live in the great state of Illinois. Always lots of headlines here. So what are a couple of things you’d like to point out there?

Karel: Yeah, I think what surprised was definitely the strength of the job market and the consumer spending was up. This resulted, combined with the strong labor market, in tax revenues across the board being up about 10%. So that was very good. Of course, particular states that kind of stood out, I wanted to mention California, it’s the largest issuer of municipal debt. It dropped 14 spots in our State of the States. On the other side, we saw some resource-dependent states that had lagged at the onset of the pandemic when commodity prices were so low, they improved. Alaska stands out as it being the state that improved the most in this year’s report.

Some other interesting observations we made this year was sort of this decoupling of population growth and the housing market we had in prior years, seeing those kinds of correlated very well. This year you saw that, as I mentioned, being decoupled somewhat, Hawaii, New Mexico stood out. They had very strong housing market growth, but lower population growth numbers than other states. So I think that’s an interesting observation we made and occurs to see if some of those trends are here to stay.

And then lastly, sort of on the socioeconomic front, it’s worth mentioning that some states have much higher per capita income levels than others. And we have a graph in the report where we show that the wealthiest 5 states have on average somewhere between 1.5 and 1.7 times the personal income per capita level of the lowest five states. So that’s quite significant.

Stewart: Yeah, that’s interesting. I mean, I know anecdotally that there are some folks who are friends who have made some decisions about where they live based on the tax rate of that state. How big a deal is shifting population? It seems as though high-tax states could, with the world that we live in some locational flexibility, do you consider that at all?

Karel: Yeah, we have a metric in the report that we take from the tax foundation which ranks a state’s tax climate. Now it’s worth pointing out that there are obviously two ways to look at this. One is the absolute rate, then some will be higher than others and others, or another way to look at this is more in terms of does the state collect an income tax, for example. I think that’s what people often think about when they retire in, let’s say, Florida that has no income tax. That’s driving their decision. And this is something we have focused on for several years now where we look at population changes. Can we somehow correlate this with state tax climate?

When we look at the underlying drivers behind population changes and we use data from a national mover, for example, that surveys its customers, it does seem that people move more for certain lifestyle changes or for jobs or to be closer to family. So having said that, that the taxes do seem to play a part in peoples’ decision. I believe it’s much more an issue of people move where there are jobs and when they move for a job, for example, that grows that economic tax base for a state, which is definitely a positive. It generates sales taxes, it drives up home prices, which positively impacts property tax collections. And if there’s something like an income tax, clearly that benefits the state as well.

Stewart: So everybody loves winners and losers, right? So based on this year’s winners, would you say that Texas, Florida, Tennessee, South Dakota and Idaho are best suited to survive an economic downturn in the second half of 2023? I think it gets into relative value, right? Because these states are not, we’re not expecting anything, any credit deterioration, but it is a relative value assessment that you’re making, right?

Karel: Exactly, Stewart. And while those states are currently the higher-ranked states, it’s not necessarily the case that they are best suited to survive a downturn. We would look at states that have solid financial footings, a diversified economy, and some states that can curb spending are in the stronger positions. Now, there might be some overlap there with the five states you mentioned, but it’s not necessarily the case that those states will weather an economic downturn better. It’s worth pointing out what happened during the great financial crisis, some states that were heavily reliant on the housing market performed very poorly, while some states with their reliance on oil and gas actually did pretty well comparatively. So with every downturn, there’s something new. I think the inflection point we bring out in the report tries to get at the fact that we are not quite sure what kind of slowdown we’re looking at.

If this is the consumer pulling back then the states with a reliance on sales taxes might be most at risk. If this is going be a recession around jobs than the states with a somewhat high reliance on personal income tax collections might perform worse. If it’s the stock market tanking that could impact the states most reliant on capital gains tax. Housing market I already mentioned. So it really is an issue of what’s the state tax climate, what’s its economy like, that’s going to impact what the impact of a recession or an economic slowdown will be on states. And then how will states deal with it? How fiscally responsible are they? Are they able during the course of a budget year to make certain adjustments?

Stewart: And you touched on this I think a little bit, but the factors that benefit these states, and it kind of weaves into what states are more vulnerable, right? Is there sort of broad-brush things that you’re looking at both on the upside and the downside there?

Karel: Exactly. We look at some of those issues. I think one I mentioned before is sort of the economy. So how concentrated is an economy? If it’s very natural resource dependent, for example, then clearly when commodity prices go down, those states are most at risk. We saw during the pandemic, people spent more and there was a bit more manufacturing coming to the United States so that helps some states more than others or the surface economy suffered more. So those are things we look at, what’s the economy made up of? Then we look at sort of its fiscal discipline and that’s something we can’t necessarily capture in the report directly, but we look at things like reserves. So high reserves levels will definitely allow a state to absorb negative impacts of a slowdown during the course of a year. Having said that, it’s difficult to come up with a general answer, but I do hope that some of that gets question you asked.

Stewart: Yeah, absolutely. And so one of the things I think that is really interesting about this report is you cover migration patterns. So can you talk a little bit about migration patterns, urban, suburban, state by state? I know there are some companies that are bringing people back into the office 5 days a week. We just did our symposium and we got a lot of people are working hybrid and a lot of folks are just able to work from wherever they choose. So can you talk a little bit about that? I think those demographics are really interesting.

Karel: Yeah. Prior to the pandemic, it was clear that people were moving out of the northeast, for example, into states like Florida, Texas, and certain states like Tennessee or these western mountain states. Then during the pandemic you saw, I want to say more interstate moves where people left urban areas and wanted to live suburban. So in some areas that meant having to actually leave the state. But if you think of in New York, you saw a lot of people actually leave New York City and move to the suburbs or even further away to more rural areas. That latter trend is now being reversed. As you mentioned, people have to come back into the office. But I want to say also because economies have opened up again and restaurants and theater and there’s more to do in a city, I think that’s driving people back to cities as well.

But the general shift of people leaving certain parts of the country to other parts of the country, that migration pattern seems to be here to stay. Now, one thing we bring up in the report is that some of these areas have seen their home prices appreciate by so much that it might have reached a point, not to use the inflection point again, but it’s possible that you’re going to see that we mentioned Utah for example, it’s possible that some places are becoming too expensive to live for some, that you’re going to see the migration reverse again. So that’s something to be mindful of going forward.

Stewart: That is interesting. I know that some areas have seen house price appreciation that’s just amazing, right? I mean, it’s hard to grasp.

Karel: And then for municipalities, what they first experienced is the run-up in home prices, which is all good, brings in property taxes, but at some point they need to start providing for their new residents as well, infrastructure, schools, other services. So there comes a point where they’re going to have to incur some expenses. And that point for some might be now, which is the reason why certain older states or more established states have these higher fixed expense burdens that we also bring up in their report. They’re sort of at a disadvantage because when people leave, they’re stuck with having to pay the bill that they incurred in prior years. These newer areas don’t have that, but they might reach a point where they’re also going to have to deal with that, which might level the playing field a bit.

Stewart: One of the things that was interesting, and I didn’t give it any thought at all prior, but as a Treasurer of a city and the planning area, I lived in a city that was growing pretty quickly. And to your point, these guys are planning intersections and roadways and it has to be planned well in advance. And when you’ve got a high level of growth, sometimes it’s hard to keep up. And I mean they face the same shortages that other people do as far as the availability and pricing of concrete and steel and everything else.

Karel: Exactly. Yeah.

Stewart: So it’s really a great point that you’re bringing up there. I mean, public works, I mean you have to pick up the trash, you have to run sewer line and water line and all that sort of stuff to these areas that folks are moving to. And it’s a great point.

Karel: Yeah, at the onset of our conversation, I mentioned some of these positives and the debt burden I brought up. We definitely saw debt levels come down a bit or grow at rates lower than they have been. I think in part it’s exactly what you bring up. That projects had become somewhat too expensive, either because interest rates going up or the cost of the product or labor shortages. So states weren’t really able to take on much more debt, which definitely helped their fiscal wellbeing. But there comes a point when you have to invest clearly, and now with interest rates that being as high as they are, it’s going to come at a cost.

Stewart: Yeah, absolutely. And I mean in the knock-on to that too is that you’ve got to have more cops, you got to have more firefighters, you got to have more sanitation workers, more street workers, more all of it. And it’s like it’s easy to forget that exists. But for our friends in municipalities, it’s reality, right? So when you think about state credit quality trends, how does that roll forward into local, state, presidential election platforms, for example? How do you make that tie?

Karel: Yeah, it’s difficult to say how state credit quality influences elections, but I can say with some certainty that elections are impacted by economic factors both at the state and national level. Local elections, as I probably don’t have to tell you, are different. And with turnouts being very low relative to other elections, but state and national elections clearly are heavily influenced by economic factors. So poor economic factors, increases in taxes, people being worse off, is going to impact the chances of the incumbent, let’s say governor or a senator or in some cases, even at the presidential level being reelected. And you’re seeing that now people are concerned about the level of inflation, and I think that’s on people’s minds. So there is definitely some relation. It’s maybe difficult to say how directly the two are related as maybe most people are not really aware of the relative strength of their credit quality versus other states, but economic factors definitely play a part.

Stewart: So this is kind of a fun question. If you had the opportunity to give advice to state and local government officials regarding municipal bonds, what would it be?

Karel: I think this goes back to where we are in the economic cycle and with the uncertainty that is ahead of us. I would tell state government officials to employ conservative revenue projections and be reluctant to lower tax rates at this point in time. I would also tell them to be mindful of what kind of long-term commitments they make, it either being through infrastructure spending or labor contracts. As we’ve seen in the past, sometimes those commitments they make, they have to pay for a very long time, and if you can’t bring in the revenues to pay for those additional expenses, then that’s going to impact your credit quality.

Stewart: Absolutely, and it’s interesting, I mean in the state of Illinois, for example, those pension obligations have had a significant impact on our fiscal position, right? It’s a great point. So this is my fun closing question. You have a choice of two, best piece of advice you’ve ever gotten or, and you can answer both if you want, who would you most like to have lunch with, alive or dead?

Karel: As a fellow cyclist, I would tell you the best piece of advice I think is what people here say: “Keep the rubber side up.”

Stewart: That’s so true.

Karel: Right. Don’t crash.

Stewart: Don’t crash. Absolutely. Well, this has been great. I mean, I’ve really learned a bunch, and it’s been a minute since I’ve actually managed municipal bonds and it’s great. I love the asset class as a very stable credit profile. And as I always used to say to people, I go, the city of Dallas is not going to lever up and take over the city of Fort Worth, right?

Karel: Yeah.

Stewart: So you’ve got a sanity check there. So it’s been a pleasure to have you on. I appreciate it very much.

Karel: No, thank you for this opportunity.

Stewart: No, it’s been great. I appreciate it. We’ve been joined today by Karel Citroen, Managing Director and Head of Municipal Credit Research at Conning. Thanks for listening. If you have ideas for podcasts, please shoot us a note at Please rate us, like us and review us on Apple Podcast, Spotify, or wherever you get your podcasts. Thanks for listening. My name’s Stewart Foley, and this is the podcast.

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Conning is a leading investment management firm with a long history of serving the insurance industry. Conning supports institutional investors, including insurers and pension plans, with investment solutions, risk modeling software, and industry research. Founded in 1912, Conning has investment centers in Asia, Europe and North America.

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