Your Money : Orange County Is but a Flash in Muni Bond Pan

If the unthinkable happens and Orange County decides to default on one or more of its bond issues, what happens to the market for California municipal bonds in general?

Maybe not as much as a lot of people think. So if you’re inclined to sell your bonds or bond mutual fund if default occurs, you should reconsider.

State officials, Wall Street underwriters and major bond investors all have warned Orange County’s supervisors in no uncertain terms against walking away from their bond debts, despite the county’s bankruptcy and its horrendous near-term financial outlook. State Treasurer Matt Fong added his voice to that chorus on Thursday.

Those warnings, usually aimed specifically at the county, also are meant to reverberate in the boardrooms of the 186 municipalities and agencies that invested in the county’s doomed investment fund, and which also may face severe financial stress that could affect their ability to repay bonds.

The bond market’s message is that a default by Orange County could cause a sort of nuclear winter for California muni bonds, sending investors fleeing from many disparate issues, stymieing future bond issuance and sharply raising interest costs for those California municipalities and agencies that might still be able to sell bonds.

Even allowing for the usual hyperbole in these situations, the rhetoric has become extreme. Pleading for the state to take a role in resolving Orange County’s mess, brokerage CS First Boston recently issued a report stating that the bankruptcy “has had a significant negative impact on the value of the investment portfolios of numerous California residents.”

One piece of evidence cited by the brokerage: Between Dec. 6 and Feb. 1, as market interest rates have trended lower, California muni bond mutual funds appreciated in value by 1.8%, while national muni funds appreciated by nearly 3%.

Yet that hardly suggests that the equivalent of a financial earthquake has occurred in the California muni bond market, despite repeated hints by certain Orange County officials that bondholders there may share in the county’s investment losses.

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In fact, it has been business as usual for many California municipalities that have needed to borrow via bonds since Orange County’s bankruptcy filing on Dec. 6. Securities Data Co., which tracks bond issues, counts 29 California offerings so far this year, raising $678 million.

Moreover, the interest rates being paid by the issuers don’t appear to be significantly above what would have been expected without Orange County’s debacle, some bond underwriters say. “There’s no noticeable penalty,” says Ken Williams, managing partner of underwriting firm Stone & Youngberg in San Francisco.

Others may argue over what constitutes a “noticeable” premium in bond yields. The CS First Boston report, for example, contends that California municipalities with floating-rate short-term debt outstanding are paying 0.18 point more in annualized yield than they might be paying without Orange County’s specter looming.

The added annualized cost if that premium stays: $28 million on $15.5 billion in floating-rate debt.

Obviously, every dollar California entities pay in interest is a dollar that could have gone to equip schools, build prisons or retire debt, among other more beneficial uses. Yet there’s no evidence that Orange County’s crisis, serious as it may be for that jurisdiction, has caused investors to demand “junk” level yields on California bonds en masse.

It’s also true, however, that the market so far has dealt only with the threat of default--not with actual default. Orange County and its municipalities are current on interest and principal payments on all outstanding notes and bonds.

But even if the county finds itself unable to make good on certain obligations, it may be vastly overstating the case to say that other California municipalities, or the state itself, will suffer horribly from the aftereffects for years. West Hollywood isn’t Orange County. Neither is Fresno. Tourists know the differences. So do investors.

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Consider the case of the Washington Public Power Supply System, which before Orange County was perhaps the most celebrated municipal-finance disaster. In 1983, WPPSS defaulted on $2.25 billion in bonds used to finance what would become mothballed nuclear reactors.

As with Orange County today, Wall Street in 1983 warned that WPPSS’ failure to pay 100% on its bonds would cost the state and its municipalities dearly. Many investors would never trust a Washington bond again, the story went. It was a reasonable assumption.

Yet when the state of Washington issued new bonds a few months after the WPPSS default, the deal negotiated with brokerage Salomon Bros. was estimated to carry a yield of 0.40 point above market rates, according to Tim Kerr, the state’s administrator of debt management. That was a penalty, to be sure--but not a debilitating one.

And within a year, the premium demanded by the market on Washington bonds disappeared entirely, Kerr said, even though it became apparent that WPPSS bondholders themselves would recover only pennies on the dollar. For investors in Washington bonds generally, “Greed overcame fear in a lot of respects,” Kerr said.

That’s the harsh truth for Orange County bondholders who hope that the threat of widespread fallout will persuade county supervisors to do the right thing. The California muni market is simply too mammoth, and investors are simply too hungry for tax-free interest, to be affected more than momentarily by one issuer’s default--even one as large as Orange County.

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Still Borrowing

California municipalities haven’t been shut out of the debt market as a result of the uncertainty caused by Orange County’s bankruptcy. Among the issuers that have floated bonds this year:

Millions of Issuer Date dollars raised Needles Public Fin. Auth. Jan. 5 $4.45 Santa Rosa Housing Auth. Jan. 5 7.24 City of West Hollywood Jan. 17 9.94 Kern Comm. College Dist. Jan. 17 44.30 L.A. Harbor Dept. Jan. 18 180.00 Fresno Unified Schools Jan. 18 10.51 L.A. County Metro Trans. Jan. 18 169.50 San Bernardino County Jan. 20 40.40 Vista Unified Schools Jan. 30 2.99

Source: Securities Data Co.