Connecticut's Tax Delinquency Crisis: Risks to Bondholders and Opportunities in Infrastructure Bonds

Connecticut's fiscal health is at a crossroads, with unresolved tax delinquency issues, legislative gridlock over revenue policies, and sector-specific financial strain threatening its creditworthiness and investor confidence. For municipal bondholders, these risks create a nuanced landscape—requiring a sharp focus on asset-specific resilience while avoiding exposure to systemic vulnerabilities tied to the state's tax scaffolding. Here's how to navigate the risks and seize opportunities.

The Tax Delinquency Time Bomb

Connecticut's property tax delinquency system, with its archaic 18% annual interest rate (set during the 1980s high-inflation era), has become a flashpoint. While lawmakers push to lower this rate to 8-12%, municipal leaders warn this could reduce revenue by hundreds of millions annually. The stakes are high: if delinquent tax collections falter, it could erode budget surpluses that are already projected to shrink as federal aid declines.

The state's $2.3 billion surplus for FY2024—its second-highest ever—masks vulnerabilities. Sales tax growth has stalled, and corporate tax revenues are stagnant. Meanwhile, a proposed 1.75% capital gains surcharge on high earners (set to expire in 2029) is seen as a temporary fix for funding a child tax credit. If federal Medicaid and education cuts materialize (up to $880 million annually), the state may face a fiscal squeeze, forcing tough trade-offs between debt service and services.

Credit Ratings: The Utility Sector's Cautionary Tale

Connecticut's utilities offer a stark example of how regulatory missteps can ripple across the broader economy. Moody's and S&P have downgraded key utilities like Connecticut Light & Power and Yankee Gas due to delayed storm recovery cost approvals and PURA's aggressive rate-cutting. These downgrades have raised borrowing costs for utilities, which now face a $209 million rate hike request for 2025—a move that could either stabilize finances or further strain customer affordability.

The risk for bondholders? Connecticut's general obligation bonds could face spillover pressure if the state's regulatory environment continues to be seen as “unsupportive” (Moody's). While the state's Aa3/A rating remains stable, its outlook is fragile.

Sector-Specific Opportunities: Transportation and Sewer Systems

Amid the chaos, certain sectors are insulated by stable revenue streams and structural demand. The Special Transportation Fund (STF) stands out. With a $970 million reserve and a mandate to cap surpluses at 18% of its budget, the STF is using excess funds to reduce transportation debt, saving $680 million in interest over a decade. Bonds tied to this fund—like the $875 million 2023 issuance—offer a safe haven, backed by predictable fuel and sales tax revenues.

Similarly, sewer and water systems, managed by utilities like Aquarion (soon to be sold), have essential service demand that outpaces regulatory headwinds. Their rates are less politically volatile than electric or gas utilities, making their bonds attractive.

Investment Strategy: Avoid General Obligation Bonds, Target Infrastructure

1. Avoid General Obligation Bonds: Exposure to Connecticut's tax delinquency risks and federal aid uncertainty makes state-backed bonds vulnerable.
2. Prioritize Transportation and Sewer Bonds: The STF's disciplined debt reduction and essential infrastructure spending make these bonds a top pick.
3. Monitor Utility Bonds Cautiously: While utilities face regulatory risks, their need to stabilize finances post-downgrade could lead to selective opportunities in 2025-26.
4. Track Federal Aid Decisions: A worst-case scenario (e.g., $880 million annual cuts) would force the state to tighten its fiscal belt, but the STF's reserves provide a buffer.

Final Take

Connecticut's fiscal challenges are real, but they're not uniform. Investors who focus on infrastructure sectors insulated by stable cash flows can sidestep the state's tax delinquency and regulatory storms. The key is to avoid broad exposure to the state's budgetary whims and instead target assets where demand is unshakable. As the old Wall Street adage goes: “Bonds are promises. Choose yours wisely.”