State’s Budget Woes Make Bond Pros Wary

California faces another major budget battle in the months ahead, and that could roil the huge market for the state’s tax-free municipal bonds.

On Wednesday, one of the biggest bond-rating agencies, Moody’s Investors Service in New York, warned that it is re-evaluating its AA rating on the state’s general-obligation bonds.

Standard & Poor’s Corp., which rates the state one notch below where Moody’s does, at A+, also has warned that it views California’s trend as “negative.”

Unfortunately or fortunately--depending on your perspective--the problems facing the state sound like the same old thing: another year, another budget deficit, and another case of California proposing to “roll over” previous years’ deficits by borrowing billions of dollars short-term.

Each year since 1990, some analysts have warned that California muni owners could see their bonds slump in value not because of the risk of actual default, but because the market would begin to see California (and, by association, its cities and counties) as hopelessly incapable of solving ingrained fiscal problems.

So far, the doomsayers have consistently been disappointed. Last year, for example, the average California muni bond mutual fund’s total return was 12.48%, slightly above the 12.35% average return on general national muni funds. Total return counts both interest earnings and the underlying price appreciation or depreciation of the bonds themselves.

In 1991 and 1992, California muni funds did produce lower average returns than general muni funds, but the differences were undramatic and were the result of California bonds appreciating less than other states’ bonds, not depreciating more.

So why should this year’s budget nightmare have any more of an effect on California bonds? The risk now, analysts say, is in the sheer magnitude of the problems built up over three years of recession--and the lack of any buffer if another natural disaster strikes, or if market interest rates turn up sharply again.

Assuming the state again rolls over its deficits, it must borrow a record $7 billion via short-term notes in late July. That would be 35% more than the loans required a year ago to close the ’93 budget gap.

What’s more, Gov. Pete Wilson’s proposed $38.8-billion state budget for the fiscal year beginning July 1 is balanced only if the state gets $3 billion in federal aid to cover social services expenses for illegal immigrants. Yet almost no one believes Uncle Sam will cough up that sum.

And to further complicate the budget mess, voters’ rejection of $5.9 billion in bond issues on the Tuesday ballot has sent Wilson scrambling to find money to pay for badly needed earthquake-retrofitting projects that would have been paid for with some of the bond proceeds.

All of this is making bond pros increasingly nervous about California. Some are even drawing parallels to New York City in 1974.

New York back then was playing the same game of rolling over deficits and going deeper into debt to pay annual budget expenses. Until finally investors decided they no longer wanted to fund New York--and the city had to be bailed out by the state. Gotham’s credit became no good overnight.

California likewise cannot continue the game of rolling over deficits and hoping the economy turns up later in the year to close the gap, analysts say. “The risk is that financial markets give up on you, and say you’re never going to solve your problems,” says Claire Cohen, analyst at credit rater Fitch Investors Service in New York.

Bernie Schroer, manager of the $13.5-billion-asset Franklin California Tax-Free fund, puts it more bluntly: “There is going to be a point where you can’t enter the debt market anymore” at will, he warns the state.

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In his fund, Schroer is already shunning new purchases of general-obligation bonds and other issues tied to the state’s health, such as Public Works bonds, because he worries that the rating agencies soon will downgrade California again.

His fear isn’t default, because the state Constitution guarantees interest payments on general obligation bonds. The issue is how much more investors will require the state to pay, in interest, before they’ll extend additional credit.

If the market demands higher yields on new California bonds, older bonds will fall in price to match current yields. That’s how bond fund shares erode--witness this year’s broad decline in fund values as market interest rates soared.

Of course, the state’s bonds make up only part of the mammoth California muni market. Steven Permut, muni analyst at the Benham Group of mutual funds, is as negative as Schroer about state general obligation bonds, but he notes that many other issues are valued independent of what happens in Sacramento. Local “essential service” bonds, for example, like water and sewer issues, still are viewed as safe-haven investments.

Also, some investors may argue that, so long as they get their interest payments, they don’t care how bonds fluctuate in price. Indeed, that appears to be the thinking behind the recent surge in small investor purchases of individual California muni bonds, even as mutual fund purchases wane, some brokers say. Barring a default, an individual bond will pay you back 100 cents on the dollar when it matures. A fund, however, never matures, so there’s no guaranteed payback in full.

Still, no one knows how even confident investors would react if the state’s budget problems were compounded by another huge earthquake, and/or by another jump in market interest rates that frightens more investors out of the bond market. California simply has no margin for error now.

State Treasurer Kathleen Brown, who is challenging Wilson for his job this year, offers a partial solution in “bonding out” the accumulated deficit--basically, issuing bonds to turn the short-term accumulated deficit into longer-term debt, to be paid off over five years.

Bonding-out has been used successfully by Connecticut and Massachusetts in recent years to solve their accumulated-deficit problems. But in each case, analysts say, there was a plan in place to assure investors that the longer-term financial problems facing each state would be addressed.

Now consider California. No doubt many people who voted down the bond issues on Tuesday are current muni owners, because we know that older, wealthier people are more likely to vote. They probably figured they were protecting their investment. After all, any security’s value depends on supply and demand; too many new bonds could depress older bonds’ value.

But the bond-rating agencies may take another view of Californians’ rejection of additional bonds for earthquake safety, schools and other projects: It may be seen as another sign of government and public unwillingness to confront reality, plan for the future and pay for a decent quality of life.

George Leung, analyst at Moody’s, notes that California and other states increasingly seem willing to OK bonds for only one kind of project: prisons. That is hardly the kind of investment that produces a long-term economic payoff.

Comparing Muni Funds

Despite the state’s fiscal woes since 1990, the average return on California muni bond funds has closely tracked returns on general national muni funds. Funds that buy insured California bonds, meanwhile, performed better in 1992 and ’93 but also suffered bigger losses in this year’s broad bond market selloff.

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Avg. total returns by fund category:

General Calif. Insured natl. muni muni Cal. muni Year funds funds funds 1990 +6.01% +6.55% NA 1991 +11.91 +11.12 +10.92% 1992 +8.71 +8.37 +9.38 1993 +12.35 +12.48 +12.83 1994* -5.67 -5.73 -7.02

* data through April 30

NA: fund category did not exist

Source: Lipper Analytical Services Inc.