Fiscal Imbalances and Borrowing Costs: Evidence from State Investment Losses

This paper examines the effects of losses in U.S. state pension funds on state borrowing costs. Since public‐employee pension obligations are generally senior to state general obligation bonds, increases in unfunded pension liabilities are a serious concern for municipal bond investors. During the 3 months ending December 2008, losses in state pension funds amounted to between 1% and 6% of annual gross state product, and between 9% and 48% of annual state revenue, depending on the state. Using this cross‐sectional variation, we find that over this period tax‐adjusted municipal bond spreads rose by 10‐20 basis points for each 1% of annual gross state product lost in pension funds by states in the lower half of the credit quality spectrum. A similar result holds for each 10% of annual state revenues lost. The effect is approximately constant over the yield curve, suggesting a constant upward shift in annual risk‐neutral default probabilities. These results are robust to controls for credit ratings and other measures of the state’s fiscal strength. They hold within credit rating categories and are strongest among states with the weakest ratings. We conclude that U.S. state borrowing costs will likely increase if unfunded state liabilities continue to grow, making state debt more expensive to finance.