Sun No Longer Shines on State’s Muni Bonds . . .

Owners of California municipal bonds may see the value of their holdings downgraded again in coming weeks. The two major bond-rating agencies that still regard California as a top credit--a triple-A state--appear likely to cut that rating to double-A soon.

A rating change probably wouldn’t have a significant effect on bond interest rates, because many investors have already braced for the move. But it would remind the hundreds of thousands of Californians who own state bonds that they can no longer take their investments for granted.

Indeed, the recession’s increasingly brutal bite on state and local finances suggests that 1992 will be a pivotal year for California and its bond owners. Unless Gov. Pete Wilson and the Legislature devise a meaningful and long-lasting solution to California’s budget woes, many bond investors could turn away, leaving the state unable to issue the hoard of new bonds that voters OKd in recent years for schools, prisons, roads and other public works.

There would also be a painful impact on existing muni bonds, with their resale value potentially depressed and the net worth of their owners--whether institutions or individuals--thereby clipped.

This week, state Treasurer Kathleen Brown travels to New York to persuade the bond-rating agencies and major investors that California remains exceptionally creditworthy. Her visit isn’t coincidental; on Feb. 19, California will try to sell $1.4 billion in new general obligation bonds, part of the $9-billion backlog of bonds for voter-approved projects.

Wall Street clearly is nervous about California’s huge appetite for debt, given the backdrop of deteriorating state finances. The state’s budget deficit between now and mid-1993 could run anywhere between $2.6 billion and $6 billion, officials admit, depending on how long the recession holds on.

Any time a state runs deep in the red, muni bond owners get nervous. They want to know that they’ll be paid the tax-free interest they’re owed on their paper each year, and they want assurances that the state isn’t jeopardizing the eventual return of their principal.

Brown, in Los Angeles last week to address the Bond Club of L.A., told the well-heeled audience at the downtown Jonathan Club that her arguments to the rating agencies “will be quite vigorous. . . . It’s my belief that California is a triple-A state, if you look at our resources in the long-term.”

Nonetheless, officials at Moody’s Investors Service and Fitch Investors Service, which still maintain triple-A ratings on California, seem likely to follow competitor Standard & Poor’s Corp., which cut California to double-A in December.

George Leung, a managing director at Moody’s, said Friday: “We are increasingly concerned about the growing size of the budget problems in California. We feel that California is facing significant budget pressures that are both cyclical and structural in nature.”

Brown, a Democrat, has been highly vocal about the severity of the state’s problems, among them soaring job losses and the economic challenges posed by neighbor states such as Nevada and Utah. That has riled Republican Gov. Wilson and other state officials, leading to vicious partisan rhetoric--none of which helps the confidence of bond investors.

So far, the extent of the damage to the portfolios of California bond owners has been mixed:

* Many bonds issued by smaller cities and school districts within the state have tumbled in value since summer, on worries about the issuers’ ability to pay. Most suspect are Mello-Roos bonds often used to finance local real estate development. “It’s hard to quote prices on these bonds,” says David MacEwen, bond portfolio manager at mutual fund firm Benham Capital Management in Mountain View, Calif. Because of investor fears, “they just aren’t trading.”

* State general obligation bonds, or G.O.s--the kind Brown is charged with selling--have held their value well in recent months despite the state’s budget woes. These bonds, used to finance major public works, are backed by the full faith and taxing power of the state, and so are considered the safest issues.

All in all, a diversified portfolio of California bonds remained a good investment in 1991. The average bond mutual fund that buys only California bonds posted a “total return” of 11.1% last year, according to fund-tracker Lipper Analytical Services Inc.

Of that 11.1% return, investors earned about 6.1% in tax-free interest for the year--the same as a 9.75% yield on a bank CD for someone in the top federal and state income tax brackets. The rest of the return was appreciation of the bonds, as falling market interest rates made older bonds more valuable.

But what about this year? A major question is whether Brown will be able to sell a planned $3 billion to $5 billion in new G.O. bonds without depressing the value of older California bonds through sheer oversupply.

Individual investors are a key part of the equation. Through their direct bond purchases and through California-bond mutual funds, whose numbers have mushroomed in recent years, individual Californians have become principal financiers of the state since 1986.

It’s uncertain how badly they would react if they began to see the value of their fund shares slide, either because of a bond glut or because of rising market interest rates.

With short-term interest rates at 27-year lows, Brown believes that individuals will continue to put money into longer-term bonds. Benham’s MacEwen agrees. “That demand is just enormous,” he says. Of worries that supply will exceed demand this year, MacEwen notes that Brown sold a record $4.1 billion in G.O. bonds last year. “People didn’t think she’d be able to do it, but she did,” he says.

It helps that, despite the surge in borrowing in recent years, California still has relatively low debt for its size compared to most other states. Interest on bonds now eats up just 2.4% of state revenue. The average for all states, according to Moody’s Leung, is about 5%.

Likewise, California ranks 28th among the states in debt per capita--$305 for each resident in 1991.

The danger is that politicians could seize upon those figures to try to take California deeper into hock than investors would be willing to fund.

Already, in addition to Brown’s huge bond backlog, plans are being drawn up in Sacramento to authorize another $6 billion in bonds this year to build more schools, roads and other projects. Such a construction boom would create jobs and potentially could jump-start the state economy.

But how much California debt investors are willing to swallow remains to be seen. A nervous Wall Street--and Californians themselves--could balk unless the state’s fiscal outlook improves over the next few months.

As California Bond Sales Soar . . .

General obligation bond sales:

1981: $140 million

1991: $4.1 billion

. . .California Bond Funds Multiply

Number of California-only bond mutual funds:

1981: 1 fund

1991: 55 funds

Bond mutual fund numbers include long-term, uninsured funds only.

Source: California State Treasurer; Lipper Analytical Service Inc.