Southern California residents are all too familiar with the cloudy weather patterns that can damper hopes of a sunny day. A similar cloudy situation surrounds the California municipal bond market as the state continues to struggle with how to close a $24 billion budget deficit. While certainly not new, the story took a more serious tone last week as the state began to issue IOUs. California municipal bonds, particularly state general obligation (G.O.) debt, continue to trade weakly in response.
- We expect pressure to persist near-term on California municipals due to uncertainty both over the budget impasse and potential short-term borrowing that might impact the broader California market.
- State of California G.O. bonds might be downgraded further but we view the probability of default as remote.
- We view current weakness in high quality California municipal bonds as a buying opportunity for longer-term investors.
The issuance of IOUs prompted Fitch Investor Service on July 6 to downgrade state of California G.O. (California St.) bonds to BBB from A- and maintain the bonds on watch for another potential downgrade. Moody’s and S&P, which rate state of California higher at A2 and A, respectively, have yet to take additional action but also have the state on watch for a downgrade. California is by no means alone in dealing with budget issues but garners more than its fair share of headlines even though states such as Massachusetts, New York, and New Jersey also suffered above average tax revenue declines according to the Rockefeller Institute.
As legislators work to resolve the budget, pressure will likely remain on California municipal bonds and California St. G.O. bonds, in particular. Politicians will cite dangers of raising taxes or cutting expenses too much. Program cuts and lost jobs will also keep sentiment negative. Even if a budget resolution is passed, it may not completely remove pricing pressure on California municipal bonds. The state might need to issue a short-term note in August to cover part of the budget gap or to cover short term cash flow needs. Depending on the size of the new bond issue, a higher yield might be necessary to attract enough investors. Higher yields on short-term securities will likely restrain prices on longer-term issues as investors are drawn to more attractive short-term bonds with less interest risk. That was the case last fall when California offered a 4.5% yield on nine month notes. Both budget negotiations and the possibility of additional borrowing will keep the market volatile over the very near term.
California Budget High Priority
It is important to note that California St. G.O. debt service is a high priority within the budget. Timely payment of interest and principal is second only to education expenses in California. Furthermore, payment of debt service is an on going appropriation so bondholders still get paid despite the lack of a budget. IOU’s allow the state to defer cash payment to lower priority obligations such as tax refunds, student aid, and corporate vendors. Fitch reports the State of California could continue to issue IOUs into September before day-to-day cash flow constraints could potentially lead to a delay in certain bond interest payments. Bond service was never interrupted in 1992, the last time IOUs were issued as a result of a 61-day budget impasse under then governor Pete Wilson.
The budget primarily affects California St. G.O. bonds—many other California municipal bonds may not be affected. Municipal bonds come in many different forms. Bonds issued by a utility, such as Los Angeles Dept of Water and Power, are usually backed by a dedicated revenue stream. Other municipalities have bonds backed by dedicated tax revenues not impacted by state funding. Over the longer term, these essential service revenue bonds, G.O. bonds from large metropolitan areas, and school district bonds, are less likely to be impacted from the budget, if at all, even if current market pricing reflects concerns over the broader California municipal market. We view the probability of a State of California G.O. default as remote.
California state revenues are budgeted to be $90 billion for fiscal year 2009-2010 that began this July. After approximately $36 billion is set aside for schools (the state mandated 40%), state debt service, which totals roughly $5 billion, is next inline to be paid. This process leaves $54 billion to cover $5 billion in debt service costs. This process interest expense coverage ratio of 10.8 (54 divided by 5) is higher than many similarly rated corporate bonds.
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The cost to service debt amounts to only 5.5% of state revenues and many other expenses, including state employee wages, have to be cut first before affecting bondholders. The State of California is also a sophisticated borrower and depends on its ability to borrow in the municipal bond market given the sheer size of the state economy. By defaulting on state obligations or even delaying interest payments, the state faces potentially higher borrowing costs in the future as investors would likely demand higher yields. The state wants to avoid this outcome at all costs and does not want to compromise future access to capital markets.
Too Big To Fail – Yeah Right
The “too big to fail” argument has so far been ignored by the municipal market. We view Federal Government support also as a low probability but still with an outside chance of occurring. So far, the federal government has rebuffed California but given the state represents 13% of U.S. GDP it may be important enough to reconsider. We believe current weakness actually presents a buying opportunity for longer-term investors. Part of the weakness in California municipals is due to illiquid trading conditions. Bond dealers are in better financial health but remain capital constrained and risk averse. As selling picked up in California municipals, prices dropped simply from dealers employing risk management and providing lower prices. Dealers did not want to load up on municipal bond inventory from a single state and the onset of quarter end exacerbated this condition as firms tend to take a conservative approach. This helps explain why California municipals, state G.O. bonds in particular, held relatively stable so far in July despite the downgrade by Fitch.
We would argue that a similar downgrade by either S&P or Moody’s is already priced in to state G.O. bonds. Chart 1 shows that current California G.O. yields are much wider relative to the National AAA average municipal yield than during the 2003/2004 period, the last time California G.O. bonds were rated BBB. As of July 10, 30-year state of California St. G.O. yields are roughly 1.0% higher than comparable AAA-rated bonds and, among 10-year maturities, the spread is wider with California St. G.O. bonds yielding 5.0% versus the AAA-rated average yield of 3.25%, a 1.75% yield advantage. California’s economy is the eighth largest in the world and California taxable Build America Bond (BAB) yields compare favorably to other large sovereign issuers. The yield disparity reflects the market already pricing in credit deterioration. Government of Poland 5-year notes (rated single-A) offer a similar yield to California BABs but to exceed a 6% yields, investors would have to consider below Investment-Grade Emerging Market Debt.
Where are the risks?
Smaller municipalities more dependent on state funding are likely to be most at risk from additional budget cuts. Bonds from these municipalities tend to be lower-rated to begin with as rating agencies often cite the lack of diversified revenues as a risk when assigning ratings. Bonds subject to annual appropriations from state revenues might also be at greater risk. We do not expect widespread defaults as a result of the budget crisis alone, but should they occur we would expect the defaults to be largely contained to below investment grade rated issues.
Mutual fund investors need not alter their investment plan as a good fund manager would likely steer clear of issuers subject to budget cuts or a limited revenue base. California’s budget issues are well known and the result of structural issues—it is the only state that requires a two-thirds super majority to approve tax increases and lacks veto power on voter approved initiatives that draw on state revenues. A good fund manager’s investment process would limit adverse exposure. For individual bond buyers, the mantra of high quality and good diversification with general obligation and essential service revenue bonds has never been truer.
This report was prepared by my firm LPL Financial.
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