Some Bond Buyers Avoiding California

For years, people have warned that California’s perennial budget brinkmanship would eventually drive investors away from its bonds.

For years, there was no sign of it happening. Fixed-income investors showed a seemingly boundless appetite for California’s municipal securities, even as state and local borrowing ratcheted upward.

But now, with the Legislature deadlocked over how to address a $38-billion budget gap, the state’s bond rating deteriorating and an effort to recall Gov. Gray Davis apparently gaining steam, some muni investors finally may be losing faith.

Los Angeles money manager Marilyn Cohen, whose Envision Capital manages $120 million for wealthy individuals, said she has “begun tippy-toeing away” from California’s general obligation bonds.

“It just wouldn’t be prudent not to,” Cohen said.

By the end of the year, her investors’ holdings in California general obligation bonds will be trimmed by 6% to 7%, the biggest one-year reduction Cohen can remember.

Wall Street traditionally cuts California a lot of slack and probably won’t get overly excited if the state misses its constitutional deadline Sunday for the Legislature to approve a new budget, experts said. But along with the recall campaign, last winter’s bond-rating downgrade and the political impasse in Sacramento, it’s another black mark on an increasingly dark scorecard, these people said.

“Investors and ratings agencies are increasingly uncomfortable,” said Robin Rappaport, senior municipal credit strategist for Payden & Rygel in Los Angeles. “They’re looking for the legislators to get together and give a little.”

The longer the state fails to address its long-term problems with either permanent spending reductions or tax increases or both, the greater the concern will grow, she said.

Some experts are still hopeful that solutions to California’s financial woes will emerge.

“All the discussions seem to be very negative, but the anticipation is that they’ve worked through these things in the past and they’ll probably work something out this time,” said Dan Solender, portfolio manager of Vanguard Group’s California bond funds.

Yet Solender also has been “lightening up” on California general obligation bonds, turning instead to school district bonds or other municipals not within the Sacramento orbit.

Californians don’t have to pay state or federal income tax on interest they receive on most bonds issued by the state, boosting the yield when adjusted for taxes. That creates a powerful lure to high-income people in a high-tax state like California and helps prop up demand for the state’s paper.

But that doesn’t mean investors aren’t asking to be rewarded for accepting the extra risk posed by California’s huge shortfall and the political squabbling.

David Blair, senior analyst at Nuveen investments, estimated that California is paying $170 million this year in additional interest and fees on its bonds over what it would pay in “normal” times.

With California’s rating at “A,” tied for lowest among the states, yields on its bonds are as much as half a point higher than the average AAA state bond, he said. In dollar terms, if the state issues $5 billion in general obligation bonds this year, the extra cost is $25 million to $30 million a year.

Moreover, the state must pay stiff fees for stopgap borrowing during its current fiscal crisis. On Wednesday, for example, California sold $11 billion in short-term warrants to keep the state solvent through August.

To get the deal done, Blair said, the state had to pay about $110 million in extra interest and fees, including an $84-million “credit-enhancement” arrangement under which Wall Street investment banks provided a kind of insurance for the warrants.

The assumption that investors will “just buy California debt endlessly” can lead to the view that all problems can be solved by simply issuing more bonds, Blair said. “You can dig yourself such a hole that it will be very hard to get out of.”