Budget Woes Put California’s Muni Bonds to the Test
Concern is growing about the credit quality of California state and local municipal bonds, as the state economy continues to sink.
Investors aren’t worried about massive defaults of Golden State bonds, because that’s improbable even in the worst-case scenario. But the market’s increasingly uneasy feeling about California could mean that the state and its municipalities will have to pay more to borrow in the future.
And if that’s the case, the hoards of California muni bonds that investors already own could decline in value, or at best just stay flat--even if bonds of other states are rising in value with the general slide in market interest rates.
Today, California will offer nearly $450 million in new general obligation bonds to the public. The bond sale will be an important test of the state’s credit worthiness, because muni bond experts say it has only been in the past few weeks that sentiment toward California has begun to worsen:
* “Investor interest over the past month (in California bonds) has been significantly less than what we’d seen before,” said Edward Droesch, an investment banker with Goldman, Sachs & Co. in New York. His firm has traditionally been a major dealer in California bonds, but Droesch said, “I think this (bond issue) is going to be a tough sale.”
* Bernie Schroer, manager of the largest mutual fund investing solely in California bonds--the $12.5-billion Franklin California Tax-Free fund in San Mateo--said investor demand for fund shares has trailed off in recent weeks. That’s partly seasonal, Schroer said, but he also blames “a lot of bad press about the state’s economy.”
* A new report by brokerage Sanford C. Bernstein & Co. in New York predicts that California’s credit rating will drop from the coveted AAA to AA within 18 months because of the weakened economy.
For now, however, California remains a top credit--at least in the eyes of the two independent bond rating agencies, Standard & Poor’s Corp. and Moody’s Investors Services. Both agencies on Tuesday reaffirmed California’s AAA rating, the highest possible rating and one shared only by nine other states. California has been rated AAA since 1986 by S&P;, and since 1989 by Moody’s.
However, S&P; admits that its ratings outlook for California is “negative,” meaning a downgrade is very possible unless the state “swiftly” adopts new budget-balancing measures.
Fear of another yawning state budget deficit is intensifying because there has been no pick-up in the California economy--which means sales tax and income tax revenue could fall at least $2 billion short of the current annual $55-billion state budget, S&P; says. When you can’t pay your bills, your bondholders get nervous.
There’s another problem as well: The state and its municipalities are trying to sell more bonds even as investors turn wary. Zane Mann, editor of the California Municipal Bond Advisor newsletter, says $18 billion of new California state or local muni bond issues have been floated so far this year. That’s already surpassed the $15 billion floated in all of 1990.
Franklin’s Schroer says state Treasurer Kathleen Brown is “doing what the voters elected her to do”--raise billions of dollars via bond issues for major projects that had been approved by the electorate in recent years, then backlogged.
The question now isn’t whether California will be able to borrow over the next year, but at what price. Up until recently, many bond experts had argued that even if California’s credit rating fell from AAA to AA, the state wouldn’t have to pay much higher bond yields--because after all, this is California, “the nation’s most important state.”
Now, some people aren’t so sure about that thesis. “I wonder if we’ve been living in some daydream,” Mann says.
The AAA-rated 20-year bonds that California will sell today, for example, are expected to pay about 6.45% in annual interest. In contrast, states rated AA, such as Florida and Washington, pay closer to 6.6% on such bonds. If California’s economy slides further, and the AAA rating is cut to AA, investors who own older California bonds could see the value of those bonds reduced accordingly so that their yields are more in line with other AA-rated states.
Does that mean all California muni bond investors should bail out now? Probably not. One irony here is that, to fix its worsening budget problems, the state may have to raise income tax rates--which would simply make its own tax-exempt bonds that much more attractive to California residents who are hungry for yield.
As the chart above shows, you’d have to earn 10.3% on a taxable bank savings certificate to match the 6.45% tax-exempt return of a California muni bond, if you’re in the 37.4% combined federal/state marginal tax bracket.
Even shorter-term California bonds offer very attractive returns: 5.3% on a five-year muni is the same as 8.5% on a bank CD. Where can you find 8.5% anymore?
But given the backdrop of the state’s budget troubles, and investors’ growing concern about California bonds, Mann advises his subscribers to buy only cautiously: Stick with the highest-quality issues, in particular those that are privately insured. Avoid muni bonds used to help finance real estate projects or other non-essential projects.
And above all, buy California bonds or bond mutual funds in installments over the next six months or so, rather than all at once now. That way, if the state is indeed forced to pay higher yields, you can buy into that rising trend.
