Wall St. to state: Feel free to borrow
It’s too bad that Wall Street isn’t worried about the borrowing binge that California voters will be asked to approve Tuesday.
A little concern might translate into higher interest rates on the state’s tax-free bonds, which many yield-starved investors no doubt would appreciate.
But the official line from the major bond-rating firms is that California can easily afford the five statewide bond measures on the ballot. Combined, Propositions 1B, 1C, 1D, 1E and 84 would authorize the issuance of $42.7 billion in general obligation bonds for an array of public-works projects.
That would add to $60 billion in state bond debt already outstanding and another $30 billion that voters have authorized but the state hasn’t yet sold.
How much debt is too much? Fiscal conservatives say the state already owes too much and that adding on more obligations is folly. But professional bond market watchdogs -- the people whose opinions count with big investors -- aren’t worried. And that’s important for bond owners and potential buyers to understand.
“The state’s overall debt burden is likely to remain manageable,” said Douglas Offerman, who watches California for Fitch Ratings in New York.
John Wiley, co-manager of the Franklin California Tax-Free Income mutual fund, one of the largest municipal bond funds, says he’s losing no sleep over the prospect of a mountain of new state debt that could, in theory, depress the value of outstanding bonds over time.
“I wish we could be more alarmist,” Wiley said -- because he’d love the chance to grab new bonds at higher yields.
Instead, the trend in long-term California municipal bond yields has been down since June. The annualized yield on 20-year general obligation bonds has slid from 4.68% in late June to 4.35% as of Friday, which is near the lowest level in a generation.
Long-term interest rates in general have fallen amid expectations that a weakening U.S. economy could spur the Federal Reserve to begin cutting short-term interest rates in 2007.
A 4.35% state bond yield may not sound like much, but it has to be viewed in context. Because that yield would be exempt from federal and state income tax in California, it’s worth much more than its face value, depending on an investor’s tax bracket.
It doesn’t take much income in this state to be facing a combined federal and state marginal tax rate of 31% or more. For a couple, taxable income of about $61,000 would do it.
If your marginal tax rate is, say, 35%, a 4.35% tax-free yield would be the same as earning 6.7% on a taxable investment. You aren’t going to find that kind of yield at the bank or on high-quality corporate bonds today.
For comparison, the yield on a 20-year U.S. Treasury bond was about 4.9% on Friday.
Investors who are hoping to boost their portfolio income with municipal bonds over the next decade or longer ought to be rooting for all of the bond propositions on Tuesday.
If you’re a bond buyer, more supply is better than less, because it means more competition for investors’ dollars.
More borrowing by the state could mean that California’s local municipal borrowers -- school districts, for example, or cities selling bonds to pay for housing- development infrastructure -- would have to ante up higher yields to get their securities sold.
That could make the market more interesting in the next few years for fund managers like John Miller, who runs the newly launched Nuveen California High Yield Municipal Bond Fund. His goal: Find bonds that offer above-average yields without high risk.
High-yield muni bonds, Miller says, often provide investors with better after-tax returns than they could get on corporate high-yield bonds, but with far less risk. For one thing, bond defaults by municipal issuers are rarities compared with what has happened in the corporate sector historically.
To some fiscal conservatives, the gut reaction to the bond issues on the ballot is that the state can’t afford them. They believe California ought to fund infrastructure projects such as roads, schools and levees out of current tax revenue, and cut back on other spending to do so.
But Wall Street believes that bonds are in fact the right way to pay for long-lasting capital projects because the debt is repaid over time by current as well as future taxpayers, all of whom may benefit from the projects.
As for the state’s ability to handle the debt that the ballot propositions would authorize, there is one main barometer that Wall Street considers: the percentage of state revenue consumed by debt service, meaning interest and principal payments due on bonds outstanding.
Infrastructure-related debt service ate up 4.2% of the state’s revenue in the last fiscal year. If all of the previously authorized debt is issued, and all of the bond propositions on Tuesday’s ballot pass, the state legislative analyst’s office estimates that debt service would peak at 5.9% in fiscal 2010-11 and decline from there (assuming voters don’t approve more bonds).
A 6% debt service burden doesn’t trouble the bond-rating firms. David Hitchcock, who tracks California’s fiscal health for Standard & Poor’s, says a 6% debt-service level would be “moderately high” in relation to other states, but still well below the levels of some more aggressive borrowers. New York’s debt-service burden is 8.6%, according to S&P; Massachusetts’ is 7.9%.
By another measure -- state debt per capita -- California ranked 13th of the 50 states in 2005, S&P; calculated. The state’s tax-supported debt per person was $1,473, well below the levels of Connecticut, Illinois, Washington and others.
Although the ballot issues would mean more debt issuance over the next 10 years, California’s population also is expected to rise -- and with it, the state hopes, the size of the economy and the tax revenue it generates.
But if California is in such great shape in terms of its debt load, why does it have the lowest bond rating of any state other than Lousiana? S&P;, for example, rates the Golden State “A+,” while most other states get either an AA or AAA grade.
Here’s where the fiscal conservatives have a good point: The state’s ability, or willingness, to balance its budget each year remains suspect. “That’s embodied in the state’s credit rating,” said Fitch Ratings’ Offerman.
California racked up annual budget deficits in the early part of this decade, which was one of the issues that led to former Gov. Gray Davis’ recall by voters in 2003.
The way out of that budget mess was more debt: $11.3 billion in bond borrowings to cover the state’s accumulated deficit.
The way bond-rating firms do the math, the state is at serious risk of facing more annual budget deficits over the next few years. That risk could surge if the economy ebbs and tax revenue shrinks, which was the chain of events beginning in 2001.
If the budget goes back into the red, the infrastructure bond-debt burden suddenly might begin to look much more onerous.
Almost nobody on Wall Street believes that California ever would renege on its debt, short of half the state crumbling in a catastrophic earthquake. Even so, investors determine what interest rates they’re willing to accept from borrowers based on relative risk.
Another budget crunch could have the same effect as the one in 2003: California bond yields could temporarily soar. At the peak of yields in 2003 you could buy a 20-year general obligation bond paying 5.5% a year tax-free.
Why not wait to buy? First, there’s no guarantee of a budget-crisis replay. And the problem for many investors is that they need income now. California bond yields may be lower than many investors might like, but they’re still appealing relative to many of the alternatives.
Municipal bonds also offer something else: a way to add stability to a portfolio. Muni bond values aren’t going to suffer the volatility that can hit the stock market periodically, for example.
“It’s not exciting, and it’s not going to be exciting,” Franklin’s Wiley says of the muni market. But for many investors, “that’s what makes it attractive.”
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State debt burdens
State bond debt in California amounted to $1,473 per resident in fiscal 2005, ranking California 13th among the states.
The 10 heaviest per-capita debt burdens and California’s total (all data for fiscal 2005)
1. Hawaii: $3,336
2. Connecticut: $2,820
3. New Jersey: $2,800
4. Massachusetts: $2,508
5. Delaware: $2,170
6. New York: $2,084
7. Illinois: $2,003
8. Alaska: $2,000
9. Washington: $1,683
10. Wisconsin: $1,576
13. California: $1,473
Source: Standard & Poor’s
