Nov. 5 (Bloomberg) -- Allstate Corp., the largest publicly traded U.S. home and auto insurer, is paring its municipal-bond holdings because state and local governments are “not in great shape,” Chief Executive Officer Thomas Wilson said.

“We’ve just recently begun to reduce our exposure to municipals because we are uncomfortable with some of the fiscal practices of some of the government entities,” Wilson said yesterday in an interview after the Northbrook, Illinois-based company reported a third-quarter profit. “If you look at their balance sheets or income statements and put it in financial terms, they are not in great shape.”

Allstate cut its municipal holdings 8.3 percent to $22.1 billion in the third quarter as tax-exempt yields plunged to a 42-year low and governments struggled to maintain budgets amid the recession. State tax collections declined by 16.6 percent in the three months through June from the year-earlier period, the largest quarterly decline since at least 1963, the Nelson A. Rockefeller Institute of Government said in a report last month.

Officials “haven’t adjusted their spending, so they are running deficits,” Wilson said. “When we look at the risk- return profile we don’t think we are being paid enough to take that risk today.”

Within its municipal portfolio, Allstate is reducing holdings of health-care debt and zero-coupon bonds, Chief Investment Officer Judith Greffin said today in a conference call with analysts and investors.

Interest-Rate Risk

“Given our view on reducing our exposure to interest-rate risk, that’s part of the reason why we wanted to reduce our exposure to zero-coupon bonds,” Greffin said.

Municipal and corporate fixed-income securities are among the largest holdings in Allstate’s investment portfolio. Allstate was the 10th-largest institutional holder of municipal securities as of December 2008, according to the Fall 2009 edition of the Bond Buyer’s Municipal Marketplace.

State and local government bonds returned 8.1 percent in the July to September period, the best quarterly performance in at least two decades, according to the Municipal Master Index that Merrill Lynch & Co. started compiling in 1989.

Benchmark municipal borrowing costs reached the lowest level since 1967 on Oct. 1 before rebounding. The weekly Bond Buyer 20 Index dropped to 3.94 percent as cash flowing into mutual funds accelerated to a record. The index has since risen to 4.39 percent, still below the five-year average of 4.54 percent. Corporate yields during the past week rose to 4.96 percent from 4.85 percent, according Bank of America Corp’s Merrill Lynch & Co. master index.

Budget Deficits

Budget deficits totaling $16 billion have opened in 26 states since their fiscal years began on July 1, according to the Center on Budget and Policy Priorities. California had a record $26 billion deficit and New York faces a $3.2 billion budget gap this year, up 50 percent from three months ago.

“When we look at those macro trends we said it’s probably time to stitch up the sail -- to put it in a nautical term --and get focused on the parts of that business we liked the most,” Wilson said today on the conference call.

“It looks like they are reducing some of their exposure to higher-yielding municipal bonds,” Brian Meredith, an analyst at UBS AG, said today in an interview. “I don’t see why that’s inappropriate, given they are trying to de-risk their investment portfolio.”

Wilson joins Pacific Investment Management Co.’s Bill Gross in cautioning against government deficits. Gross said investors should be risk averse until local and federal leaders show the discipline needed to correct the deficits amassed by the U.S. and states such as California.

‘California’s Problems’

“California’s problems, while somewhat unique and self- inflicted, are really America’s problems,” Gross wrote in October in a commentary posted on Pimco’s Web site. State and federal lawmakers “reflect a lack of discipline and indeed vision.”

Allstate reported net income of $221 million, or 41 cents a share, compared with a loss of $923 million, or $1.70, in the same period a year earlier after fewer storms reduced claims costs, the insurer said yesterday in a statement. Operating income was 99 cents a share, missing by four cents the average estimate of 14 analysts surveyed by Bloomberg.

The insurer fell 57 cents, or 1.9 percent, to $29.05 at 4:15 p.m. in New York Stock Exchange composite trading. Allstate has dropped 11 percent this year, compared with the 18 percent increase in the Standard & Poor’s 500 Index.

To contact the reporters on this story: Jamie McGee in New York at jmcgee8@bloomberg.net; William Selway in San Francisco at wselway@bloomberg.net.

Last Updated: November 5, 2009 17:13 EST