States have long been considered the best group of issuers in the municipal bond market, thanks to modest debt levels and ample taxing power. That's still the case, though many states, including Illinois, Connecticut, New Jersey and Hawaii, are bedeviled by large unfunded pension liabilities stemming from weak investment returns and inadequate state contributions to the plans. Adding to the strain are huge and growing unfunded liabilities for post-retirement health care for state employees.

That strain was brought into sharper...