California's credit rating may be in jeopardy again, even though the governor's signature on the supposed "austerity" budget of $52.1 billion for 1993-94 is barely dry.
State Treasurer Kathleen Brown is in New York today through Wednesday, meeting with the big three bond-rating agencies to explain the budget's details.
But even before she arrived, rumors swirled in the bond market late last week that two of the big three--Moody's Investors Service and Fitch Investors Service--are likely soon to lower their credit opinions of California to A from AA.
If they do, they would match rival Standard & Poor's Corp., which downgraded California to A+ from AA last summer, in the midst of the protracted budget battle between Gov. Pete Wilson and the Legislature.
Officials at Moody's and Fitch would not say Friday that a downgrade is imminent, but Wall Street talk was that the rating agencies are more than a little unhappy with the state's carryover of a $2.7-billion budget deficit into the new fiscal year.
Essentially, California's continuing dependence on deficit financing--borrowing to make up for tax shortfalls--is giving the state the image of "Uncle Sam Jr.," a comparison not meant to be flattering.
Also, there is great concern about new off-the-books state loans to schools and community colleges over the next year. The accumulated loan total will grow to $1.7 billion.
"This expansion of off-book loans is disturbing to them (the rating agencies)," said one state official who asked for anonymity. Brown herself has called the loans "fiscally risky."
George Leung, Moody's lead analyst on California state debt, would not reply directly when asked if he thought the state's new budget was partly done with smoke and mirrors. "I'd like to answer that after (this) week," he said, referring to his planned meeting with Brown.
The state's credit rating affects only its own debt, which is a relatively small piece of the estimated $130 billion in municipal debt outstanding in California from the state, its agencies, and the myriad municipalities.
Nonetheless, the state's rating is a highly visible symbol of California's perceived fiscal health. As the rating retreats from the coveted AAA that the state enjoyed until 1991, the effect is to cast a greater pall over the California economy and its prospects.
As a practical matter, a lower credit rating also means that the state pays more to borrow new money. In turn, that can hurt existing, lower-yielding California bonds, forcing their value down in the resale market.
For now, however, it isn't clear that investors would react immediately if Moody's and Fitch cut their ratings.
Wall Street analysts note that yields on California muni bonds already are high relative to yields paid by other states, which suggests that the market has for some time viewed the state as an A credit or worse.
For example, the average annualized yield on 10 long-term California revenue bond issues tracked by California Public Finance newsletter now is 5.70%. That compares with a yield of 5.72% on a national index of 40 muni bonds tracked by the trade newspaper Bond Buyer.
Normally, California bonds should yield significantly less, in part because the interest paid--which is exempt from federal and state income tax--is worth more to a heavily taxed California investor than similar interest would be worth to an investor in a state with lower taxes.
Also, because federal tax rates will rise under President Clinton's economic plan, California investors' demand for tax-exempt muni bonds is expected to remain robust in the near term, even if the state's credit rating slips again.
In the first half of this year, the market absorbed $19 billion in new California muni issues, up 61% from $11.8 billion in the first half of 1992, according to Securities Data Co. in New York. Those figures include state and local bonds sold.
Nationwide, muni issuance is up 27% to $145 billion.
A bond that pays 5.70% tax-exempt is equivalent to a taxable bond that pays 8.91% for an investor in the proposed new 36% federal tax bracket. Yet the highest-yielding U.S. Treasury bonds (which are federally taxable) pay only 6.64% today--which means munis have little competition.
Even if a credit downgrade doesn't disrupt the California muni market immediately, however, analysts warn that a lower rating shouldn't be taken lightly. The pain will be felt as soon as market interest rates begin to rise, as the national economy grows.
In times of falling rates--the trend of the last three years--investors who are desperate for yield pay less attention to quality. So the "spread," or yield difference between high- and low-quality bonds, shrinks.
But if market rates rise, "We could see quality spreads widen pretty significantly," said Steven Permut, bond analyst at the Benham Group of mutual funds in Mountain View, Calif. Investors could demand much higher yields of lower-quality bonds.
What's more, Permut noted, if bond funds are hit by investor redemptions in a rising rate environment, "The first credits to be sold would be the weaker credits"--which could cause lower-rated California bonds to be dumped on the market, causing yields to rise further.
Of course, it's important for investors to remember that the bond-rating game is one of relative risk. If California is universally viewed as an A-rated state instead of AA, that doesn't mean that there's a meaningful rise in the risk of default. In fact, it's inconceivable that the state would ever walk away from its debts.
Rating gradations tell you whether investors trust the state government to put its financial house back in order in a timely fashion--or whether structural problems are being papered over.
This week, the rating agencies will have to be convinced that Gov. Wilson's assumptions about a recovery for the beleaguered California economy are reasonable, which would allow the state to gradually pay off its deficit.
"Seeing an appropriate plan to eliminate the deficit is very important to us," said Claire Cohen, chief California analyst at Fitch.
In addition, the big three will have to buy the idea that the state won't be back on the hook financially if its planned transfer of billions in property tax revenue from local governments to schools backfires. Some municipalities say they'll sue to block the transfer.
Even if the transfer proceeds, voters in November must agree to extend the "temporary" half-cent sales tax, which is critical to funding local governments in the wake of the transfer. If the tax goes down, troubled local governments could be back at the state's door, begging for a bailout.
Finally, the off-the-books school loans may get a frosty reception. Even though the schools technically are responsible for the debt--not the state's general fund--the rating agencies see the loans as a potential liability to the state if the economy sinks anew.
"It's clear to me that there's very strong potential for a (state) deficit next year because of the off-the-books loans to schools," said Steven Zimmerman, California analyst at Standard & Poor's.
Moody's Leung, in a revealing comment that shows the rating agencies' worries about California's structural problems, said that an area of "particular concern" is the slide in home values, on which property taxes are ultimately based. "What are the dimensions of the housing problem?" Leung asked rhetorically.
For California and its bond investors, the real risk isn't that the state's rating drops to A across the board.
The greater fear is that the A rating is just a way station on the road to the rare BBB rating-- a la the Massachusetts experience--if the state economy doesn't improve soon, and California's politicians continue to seek short-term solutions to the state's long-term problems.
California Munis Vs. National Yields
California municipal bonds traditionally have yielded less than most other states' muni issues, because California was viewed as a premier credit. But recently, California yields have been above those of other states--a measure of California's fiscal woes. Here are yields this year on an index of 10 California revenue bonds, versus the Bond Buyer index of yields on 40 bonds nationwide. Average yields weekly:
National munis: (Current) 5.72% California munis: (Current) 5.70%
Source: California Public Finance newsletter