Budget Ills Spur Higher Bond Yields

Staff Reporter

The failure of California lawmakers to resolve the $38 billion budget deficit on time is wretched news for taxpayers, who inevitably face higher taxes and cuts in state services.

But it's money in the bank for many municipal bond investors.

Relative yields on California general obligation bonds have skyrocketed since January and are nearing historic highs in the secondary market.

The yield on the state's 20-year general obligation bonds was averaging 5.28 percent last week, while yields on AAA-rated bonds in other states are averaging 4.61 percent, according to Municipal Market Data, a unit of Thomson Financial.

For bond buyers, California is a gold mine offering a spread, or yield premium, of nearly seven-tenths of a percentage point versus comparable muni bonds, at a time when interest rates have remained low by historical levels.

"When California general obligation bonds are yielding more than the market, now is a good time to buy," said Zane Mann, publisher of the California Municipal Bond Advisor newsletter. "But it's terrible if you're a taxpayer because it's costing the state hundreds of millions more in interest."

It's also not great for investors who purchased their California bonds before the crisis set in.

Bond prices, which move down when yields go up, have fallen, meaning investors who decide to sell their California bonds on the secondary market prior to maturity may have to settle for less than face value.

The price movements don't affect bondholders if they plan to hold their securities until maturity assuming the budget crisis eventually gets resolved, and California continues to pay interest on them.

High Priority

Though investors are concerned about credit risk and the potential for a credit rating downgrade, money managers say it is almost unthinkable that California would go the route that Orange County did in 1994 by going bankrupt.

The state is obligated to use whatever resources it has, including raising taxes, to pay the debt service on its general obligation bonds, which have the highest priority, along with schools issues, in getting repaid.

"I would say the likelihood of default is small but it's probably higher in California than it's ever been simply because of the size of the deficit and the political brinksmanship involved," said Mark McCray, executive vice president and municipal portfolio manager at Pacific Investment Management Co., the bond fund powerhouse. Newport Beach-based Pimco is 70 percent owned by Allianz AG of Germany.

McCray has lowered his exposure to California bonds because of concerns about the budget and the campaign to recall Gov. Gray Davis.

"I wouldn't consider getting back to benchmark weighting until there's some good clarity on the issues," he said.

The state's flexibility to resolve its financial problems is also limited by Proposition 13, the 1978 citizens' initiative limiting property taxes. Under Prop 13, local governments are required to get the approval of two-thirds of voters to raise property taxes. For school issues, the requirement is 55 percent.

Wall Street's biggest concern is that lawmakers will do the same thing they did last year patch together a budget based on optimistic assumptions and unrealistic spending cuts that forestall any real solution.

"If the bond market had a clear idea of how the fiscal problem was going to be solved, the market would actually reward the state in its issuance by tightening some of the spread," said Reid Smith, a portfolio manager at Vanguard Group, who manages two California tax-exempt bond funds.

Smith said the yields on California general obligation bonds are so attractive that it limits the downside risk. "We were significantly underweight for a while and now we started buying last month when the spreads widened because we view these bonds as holding some value," he said.

Coupon clippers

Any investor who owns a sizeable portion of municipal bonds in California likely owns general obligation bonds, the backbone of many portfolios.

Muni bonds appeal to income-oriented investors, especially those in higher tax brackets, because interest paid on bonds issued by California, its agencies and municipalities is free of state and federal income taxes for residents.

Bonds are a relatively simple financing method in which bond investors lend the state money to build bridges, schools, hospitals and other large capital projects. In return, bondholders receive fixed interest payments which has made them the most common form of income for retirees with a promise to repay the principal of the bond at a fixed maturity rate.

The recent rise in the California muni market started in January, when Davis announced that the state faced a stunning $35 billion budget gap, up from a previous $21 billion estimate in mid-November. The fiscal year began on July 1.

In January, Standard & Poor's downgraded the state's credit rating to single-A, still investment grade. (The state would have to fall four additional notches for its credit rating to be reduced to junk status.)

In May, after the governor's revised budget deficit came in at $38.2 billion and the legislature showed no sign of progress on a resolution, both S & P; and Moody's Investors Services Inc., which has an A2 rating on California munis, placed the state on credit watch for a possible additional downgrade.

California now has the dubious distinction of being tied with Louisiana and New York as the states with the lowest credit ratings in the nation.

The potential for a further downgrade could come before September. That's when California is expected to run out of cash and needs a budget in place to tap the capital markets for short-term borrowings. The governor's revised budget presumed that the state would need an addition $3 billion by September.

Debt logjam

State Controller Steve Westly has estimated that another ratings cut would cost from $400 million to $850 million in interest expense over 30 years for the $24.6 billion in bonds the state has already authorized but not yet sold.

(The high estimate translates into about $2 in additional interest expense per household for the next 30 years.)

California's troubles are compounded by the volume of bond issuances, which have flooded the market in recent years.

Currently there are 16 bills proposing at least $61.7 billion in general obligation bonds that have been introduced during the 2003-2004 legislative session.

The state issued $5.2 billion worth of bonds in the 2002-2003 fiscal year, up 32 percent from $3.9 billion in fiscal 2001-2002. Already this year, the state has issued $6.05 billion worth of general obligation bonds, with interest costs ranging from 4.83 percent to 5 percent.

For investors who own bonds, most portfolio managers suggest sitting out the volatility. For potential buyers, California general obligation bonds could actually be cheaper a few months from now amid a recall election meaning the yield spread could widen.

In June, the state raised $11 billion by selling short-term "revenue anticipation warrants," but it had to get six investment banks to stand behind the state's credit in order for the bond sale to go through.

In addition, state Treasurer Phil Angelides had agreed not to issue any more debt with longer maturity until the state has a budget agreement in place.

"This large deficit is a problem that is not going to be resolved for at least a few years," said David Blair, a senior analyst based in Irvine for Nuveen Investments Inc., a Chicago money manager. "We still view the state as a good investment over the long-term and at these yield levels we're being compensated for the risk."

For reprint and licensing requests for this article, CLICK HERE.