The recession was followed by a call from Meredith Whitney that there could be waves of municipal defaults in the years ahead. The bankruptcy of Detroit only brought that fear back up, as have serious concerns about Illinois, California and elsewhere. Now that the economy continues to improve, we are seeing the finances of states improve for the most part. Moody’s Investors Service now has revised its outlook for U.S. states to “stable” from “negative.” This is great news for tax-free municipal bond investors, with caveats. Investors have to keep in mind that local ratings remain under pressure on many levels.

The stable outlook for the states as a whole from Moody’s comes on the heels of losses in muni-bond funds that have exceeded the losses of Treasuries in many cases. The iShares S&P National AMT-Free Muni Bond (NYSEMKT: MUB) ETF is down more than 10% from its 52-week high now and is yielding about 2.91%. The PowerShares Insured National Muni Bond (NYSEMKT: PZA) ETF is now down almost 15% from its 52-week high and yields 4.12%. It is important to understand again that this may not be a full all-clear signal for city, county and other local municipal bonds. That being said, this is a good starting point as the stabilization has to start somewhere.

Moody’s believes that the slowly improving U.S. economy is supporting growth in state revenues and in reserves. As the economic recovery has been uneven, the local government outlook remains negative. At the state level, the recovery has stabilized key indicators of credit quality and federal cuts have become less likely to undermine growth ahead. Moody’s outlook for the states was negative for five years. The new outlook captures Moody’s expectations for the fundamental credit conditions in the sector over the next 12 to 18 months.

Credit quality among states remains extremely high. Moody’s went on to show that 30 of the 50 states have either Aaa or Aa1 ratings, with the reminder that these are the two highest possible ratings. The labor market gains and consumer confidence were cited, as was the strong stock market performance affected state revenues.

Many states have recorded better-than-expected financial results, and they have been able to boost their financial reserves to what are still under prerecession levels. Moody’s does give several risks to this “stable” outlook. One risk is the potential for federal deficit reduction to create drag on the economy. Another major risk is budgetary pressure from pension contributions. Employment levels are still below their prerecession peak as well.

Regional divides in economic growth across the United States are delaying full fiscal recovery in some states. It said, “The unevenness of the economic recovery is a main reason that Moody’s outlook for the local governments remains negative. Some local governments continue to suffer from depopulation, deindustrialization, and a weak housing recovery.”

Be advised that this stabilization in the outlook pertains to states rather than to local ratings. Local governments fund most of their budgets with property taxes, and there is a delay before growth in market value brings higher property assessments and higher taxes. State aid and sales taxes also have not recovered to the same extent as income or capital gains taxes have.

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