Merrill Lynch Pierce Fenner & Smith Inc. has released its "Credit Monitor" handbook on municipal bonds, in which the firm's analysts give their views of the credit quality and trends of various municipal issuers in different sectors of the market.

William E. Oliver, in the sections on state and local general obligation bonds, points out that state GOs gather their "strength" from certain sovereign powers under the Constitution and certain implied powers through the concept of federalism. Because of this, he reasons, state GOs "are generally immune from many of the restrictions and narrow economic bases that characterize local government activities."

Consequently, Oliver says state GOs possess stronger credit qualities than those issued by localities. Carrying this theme further, he says that even a state that has undergone severe economic stress -- agricultural and energy states -- would not be given a credit rating lower than Merrill Lynch's medium grade investment rating, given to bonds that provide an average degree of interest and principal protection.

The sections' overview also mentions that the states' fiscal management has improved dramatically in recent years and, as a result of the lessons learned from the last recession, the states have become "more conservative in projecting revenues and more disciplined in controlling spending."

In spite of these favorable practices, the states are facing greater responsibilities as they lose federal aid. Additionally, local governments are demanding more aid from the states. Another financial problem is the rising need for funds to rebuild infrastructures (bridges, roads, water systems, etc.).

New problems are also being created by economic upheaval in many states. Lower energy prices have seriously affected states that depend on energy-related revenue. Agricultural states have experienced similar problems.

Merrill Lynch gives credit ratings to 40 states. Their quality scale is as follows: 1, superior investment grade; 2, high investment grade; 3, medium investment grade; 4, low investment grade. Of the 40 states, 8 are rated 1, 27 are rated 2, and the remaining 5 are given a 3.

The states receiving the 3 rating are Louisiana, New York, North Dakota, Oregon and West Virginia. Of these five, four have energy or mineral-related problems. New York has other credit shortcomings.

It is unlikely that any state will default on its direct general obligation bonds, but Oliver cautions that "there are degrees of insulation from adversity between various state general obligations, as well as competing priorities within specific states, such as state lease rentals and 'moral obligations.' "

With the yield spreads between credit ratings being so compressed, investors who would like to upgrade the credits in their portfolios are now offered that opportunity.

Although the dealers' inventory has been sparse lately, the lower municipal interest rates will lead to an increase in new issues, which will provide a wider choice for investors. The buying of new issues will also avoid the odd-lot fees incurred in the secondary market. James E. Lebherz has 28 years' experience in fixed-income investments.