To balance their budgets, states are cutting funds they send to local governments, worrying many in the $2.9 trillion municipal bond market, from cities to rating agencies.

Fitch Ratings said in a report on Friday that school districts and counties will face their greatest funding reductions from states.

It said cuts in aid can result in intergovernmental downloading, where the financial burden for a service is shifted from a higher level of government to a lower level.

Even if a funding source is identified, it may prove insufficient to cover the service that needs to be provided or may not grow at the rate needed to keep pace with expenditure growth, Fitch said.

It added that local governments may not be able to cut programs states stop funding because of the essential nature or legal requirements of some services. Counties provide most of these services and are more susceptible to downloading than cities.

States give heavy financial support to schools -- roughly half of the money school systems use -- and cuts in education funding can be painful because districts themselves have little if any control over revenue raising, Fitch said.

Most states are in the final days of drafting budgets for next fiscal year, which for nearly all begins on July 1. Conservative estimates put the total budget gap they will have to close at $80 billion. Others say it tops $100 billion.

All states except Vermont must finish their fiscal years with balanced budgets. When the housing downturn, financial crisis and recession first caused their revenues to collapse, they slashed a variety of programs and hiked taxes.

With few places left to cut this year, states have begun slowing down the direct transfers and reimbursements they make to local governments, which are already struggling with their own revenue shortfalls and spending demands.

Investors are worried about the implications for the debt they hold, although Fitch noted some local governments have better credit scores than the states in which they are located.

Analyst Meredith Whitney again fanned the flames of fear of municipal defaults this week. In December, she predicted a wave of defaults this year that has yet to materialize.

Such predictions are distracting from the real story, said the research director for the National League of Cities, Christopher Hoene.

Cities will survive, but we will see continued cuts to necessary services like schools, fire and police. And the evidence shows city leaders will cut the services rather than destroy city credit ratings, Hoene said in a statement.

Investors should worry less about the risk of systematic collapse of the bond market and instead worry more about whether their local school, police department, or fire hall down the street needs a fund-raiser to stay in service, he added.

(Reporting by Lisa Lambert; Editing by Dan Grebler)