Muni Bond Investors Await Details on Budget

Many investors who own California municipal bonds are unsure whether to be elated or concerned about the approaching Schwarzenegger era.

Depending on the fiscal plan the governor-elect puts forth, California’s bonds could become much more attractive securities -- or much less so.

Bond traders said there wasn’t much, if any, reaction Wednesday to Schwarzenegger’s victory. The tax-free yields on California’s general obligation bonds have been edging up in recent days, but that reflects a rebound in bond yields in general after Friday’s upbeat U.S. data on September employment.

Because of its rock-bottom credit rating, California continues to pay far higher interest rates than most states to borrow money. A Bloomberg News index of yields on 20-year California general obligation bonds stood at 5.19% on Wednesday. By contrast, the yield on a Moody’s Investors Service index of AAA-rated 20-year muni bonds nationwide was at about 4.5%.

But muni bond experts say it’s important for investors to understand that the state isn’t suffering from a crushing debt load overall. Measured on a per-capita basis or in terms of the cost of servicing the debt relative to the annual budget, California ranks about in the middle of the 50 states, credit-rating firms say.

“It’s not a debt problem; it’s a budget problem,” said George Strickland, a muni money manager at Thornburg Investment Management in Santa Fe, N.M.

Even so, the budget outlook affects investors’ perceptions of the state’s willingness to pay its debts in the short term, and thus affects the perceived risk in owning the state’s IOUs.

The deficit-plugging plan hammered out by outgoing Gov. Gray Davis and the Legislature in the summer left a minimum $8-billion hole for next year. Bond investors’ concern is that the red ink could be far greater because Schwarzenegger intends to scrap Davis’ tripling of vehicle licensing fees while pledging not to raise other taxes.

In addition, other elements of Davis’ plan face legal challenges. Of greatest concern to bond owners is whether California could be barred from issuing $10.7 billion in planned new bonds to stretch part of this year’s deficit over five years.

Nobody expects California to fail to honor its debts. But if the deficit outlook worsens, investors might begin to demand higher yields to buy existing state bonds from other investors who want to sell, driving down the value of those securities.

That’s why bond investors are anxious for details from the Schwarzenegger camp on its budget plan, said David Blair, muni bond analyst at Nuveen Asset Management in Irvine. The market is waiting for “leadership and specifics,” he said.

A budget package that gives investors more comfort that the deficit situation isn’t deteriorating could spark a rally in the state’s bonds. Because California now pays well-above-market rates to borrow, there may be room for its bond yields to fall even if other interest rates rise.

One question raised by Schwarzenegger’s stated plans for his first 100 days is whether the new administration might try to reconfigure the state’s outstanding debt. The official 100-day plan calls for “restructuring inherited debt,” but Schwarzenegger has provided no more details on what that might entail.

Longer term, the state could try to refinance some of its $27.5 billion in general obligation debt, but that might not yield cost savings because interest rates are well above their levels of the last few years.

What’s more, Treasurer Phil Angelides last year changed the state’s borrowing terms to shift more of its debt repayment obligations to 2005 and beyond. He also borrowed more using floating-rate debt, which provided cost savings upfront but could become more expensive if market interest rates rise further.

On Wednesday, Angelides questioned whether it would be “prudent” to plan additional debt restructuring, because such steps could raise the state’s longer-term borrowing costs and worry bondholders.

Some Wall Street bankers said that though the state could reconfigure its debt or use “derivative” securities transactions with big investors to try to save interest cost, the effort might not yield much relative to the size of the budget deficit.

“That’s a lot of financial engineering, and how much cash you would free up is the question,” said one banker, who asked not to be named.