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With their budget woes frequently dominating headlines, California and New York are regularly cited as poster children for bad state finances, and investors often avoid these states’ municipal bonds as a result.

But these two big states may not be in as bad shape as many people believe. In fact, based on my team’s recent analysis, fears over the solvency of California and New York seem to be exaggerated. In contrast, Illinois is the one state that does appear particularly vulnerable from a fiscal perspective.

As I write in my new Market Perspectives piece on the 2012 outlook for munis, my team recently performed a basic examination of the financial health of the 50 states. We looked at three metrics for each state: Revenue-to-interest payments, state debt levels to state revenue and the funding of pension costs.

Revenue-to-Interest Payments: By this metric, both California and New York actually look reasonable, though nobody would describe them as exemplary. While both states have revenue-to-interest burdens below the state average, neither was among the five states with the worst revenue-to-interest burden. According to our analysis, Massachusetts had the worst revenue-to-interest burden, followed by Connecticut, New Hampshire, Rhode Island and Illinois.

State Debt Levels Relative to State Revenue: This metric paints a similar picture as the one above. New England came in as the most indebted region, with New Jersey close behind and Illinois faring not much better. California came in around average, while New York came in a bit worse than average.

Funding of Pension Costs: Of course, the metrics above don’t tell the whole story. Much investor concern about states is focused on liabilities, such as unfunded pension costs, not on balance sheets. According to a recent review by The Fiscal Times, only New York and Wisconsin have fully funded pension programs. This compares with a decade ago, when slightly more than half of all U.S. states had fully funded pension programs. And while California wasn’t among the 10 states in The Fiscal Times’ analysis with the most fully-funded pensions, it also wasn’t among the 10 states with the worst funding percentages.

So what does this mean for investors?

Municipal bonds still appear reasonably priced, particularly relative to U.S. Treasuries. While the best way to take advantage of this is through a broad, diversified municipal bond fund (such as MUB, the iShares S&P National AMT-Free Municipal Bond Fund), investors who want to opt for state-specific funds to minimize tax liabilities shouldn’t necessarily assume that New York and California funds are terrible ones to consider. Potential ETF solutions for accessing these states’ munis are the iShares S&P New York AMT-Free Municipal Bond Fund (NYSEARCA:NYF) and the iShares S&P California AMT-Free Municipal Bond Fund (NYSEARCA:CMF).

Sources: United States Census Bureau, The Fiscal Times.

Disclosure: Author is long MUB.

Bonds and bond funds will decrease in value as interest rates rise. A portion of the fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax.

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Source: Big State Doesn't Mean Bad Muni Bond