State tries to reassure bondholders after S&P sounds alarm


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California Treasurer Bill Lockyer has insisted all through Sacramento’s latest budget crisis that he would never allow the state to renege on what it owes bondholders.

Yet when credit-rating firm Standard & Poor’s on Tuesday warned that it might cut California’s credit grade -- which already is the lowest of the 50 states -- S&P flagged at least the possibility of default.


In the first paragraph of its statement, S&P says that ‘although we continue to believe the state retains a fundamental capacity to meet its debt service, insufficient or untimely adoption of budget reforms serve to increase the risk of missed payments in our view.’

S&P’s language incensed Lockyer’s spokesman, Tom Dresslar.

‘S&P raises undue alarm about the potential for missed bond payments,’ he said. ‘There is zero chance of that happening.’

Worries about the state’s fiscal fate, combined with an early-June jump in U.S. Treasury bond yields, have driven market prices of the state’s bonds sharply lower since mid-May, sending yields soaring.

Tax-free yields on 10-year California general obligation bonds were between 5% and 5.1% on Tuesday, according to several traders. The yield was under 4.4% in mid-May.

Despite the market’s jitters, Lockyer has noted many times that payment of interest and principal on the state’s $59 billion in general obligation bond debt is mandated by the state Constitution.

Only ‘thermonuclear war’ could interrupt debt repayment, the treasurer has said.

In the Constitution, bondholders come second, after education funding. S&P, in its statement Tuesday, estimated that constitutionally required spending on education would be $36 billion in fiscal 2010 (beginning July 1). Principal and interest payments of $5.7 billion in fiscal 2010 then would have to be funded before the state could divert money to other expenses.


S&P estimated that, after funding education, the state would have $53 billion in resources to cover the year’s debt service.

Isn’t that a big-enough chunk of change to make bondholders feel secure?

S&P said that although the revenue coverage of the debt service for the year appeared to be significant, the firm was concerned about cash flow -- whether week to week or month to month the state would have the cash needed to make debt payments.

‘Even if revenue for the year is sufficient to meet high-priority payments for education and debt service, we believe the timing of cash inflows and outflows could cause acute liquidity shortages with the potential to present relatively serious credit concerns,’ the firm said.

Dresslar said that was nonsense, because the state knows when debt payments are coming due and will husband cash accordingly for creditors. ‘We are not going to miss any payments,’ he said.

Lockyer has accused the ratings firms of trying to look tougher now in an attempt to restore their credibility, after the firms routinely gave top credit ratings to subprime mortgage bonds that have since exploded.

Gabriel Petek, an S&P analyst who co-wrote the California report, said S&P wasn’t implying a high danger of default. Although the firm warned that it might lower the state’s credit grade, the current rating of ‘A’ still is an investment-quality grade, he noted.


‘The rating conveys that we don’t think they will miss a payment,’ Petek said.

You can never say never when it comes to Sacramento, but investors can only hope that everyone involved knows how catastrophic even one missed bond payment would be.

-- Tom Petruno