Should California’s $16 Billion Deficit Cause Municipal Bondholders to Run?

(June 2012) Governor Jerry Brown surprised the citizens of his state when he announced that California’s estimated budget deficit would be $16 billion dollars for the fiscal year 2012-2013.  Just 4 months earlier his administration had estimated the deficit at $9 billion.

Until this revision, it had appeared that California was making progress in lowering its annual deficits. In the 2009-2010 fiscal year, the deficit hit $21 billion. However, the state had managed to reduce the deficit in the following two fiscal years to $11 billion. Instead of continuing this trend in 2012-2013, the deficit will increase by just under 70% from the previous year.

Why was there such a major revision?

  • Lower Revenues
  • Higher Expenses Constitutionally Required To Support k-12 Education

The new budget includes a major downward revision to expected revenues. The new forecast cuts the expected growth of personal income in California from 4.1% to 3.4%.  Additionally, the expected increase in capital gains taxes collected was reduced from 15% to 5%. Ironically, when the state reduces expected revenues, it increases its obligations to financially support its school systems.

What is Governor Brown going to do about the deficit?

The short answer is he is trying to increase taxes by about $8.5 billion and cut spending by about $8.3 billion (with major cuts to welfare and medicaid).  The tax increases require voter approval in November.

Has the budget deficit increased the chances of a California default?

The two main credit rating agencies have reaffirmed their ratings for California following the Governor’s budget announcement. Standard & Poor’s rates California GO bonds A-  with a positive outlook for the future. Moody’s rates California as A1 with a stable outlook. California’s credit ratings are the worst of any state, with the exception of Illinois. However, they are still in the medium area of the investment grade range. Based on the historical performance of similarly rated invest-grade municipal bonds, the default rate should be less than 0.1%, or the less than 1 in 1,000 odds.

How did the market react to the California news?

Unlike Treasury Bonds, the municipal market does not talk about prices in terms of absolute yields.  Instead the market talks about prices of municipal bonds in terms of a spread against the benchmark yield curve of AAA municipal bonds. Following the governor’s announcement, spreads for 10 year California bonds did rise a little over 0.1% (10 basis points) over the next couple days from around 75 basis points to 85 basis points. Given that the range for the spread over the last 12 months has been between roughly 70 and 125 basis points,  a move of 10 basis points is not  extremely large. The market treated the news of a larger than predicted budget deficit as a negative (and bondholders wanted additional compensation) but, it did not cause panic selling.

Are California State GO Bonds cheap?

There are two ratios that rating agencies and analysts tend to use heavily as a starting point for analyzing a municipality’s ability to repay their debt burden.

  • What is debt divided by the population?  Some municipalities/states are large like California (over 37 million) and some are small like Wyoming (under 1 million). By comparing debt per capita, you can make an easier comparison of the relative levels of debt. California is closer to $2,500, so by this measure, there are many states which are worse than California.  New York, New Jersey, and Massachusetts all have higher debt per capita than California. Massachusetts, which has higher credit rating than California from Moody’s, has almost twice the debt per capita, at just a little under $5,000.

Hold on a second. Is comparing these two states, as if each worker makes the same salary and pays the same share of taxes, a fair comparison? This bring us to second main ratio.

  • Debt as a percentage of a state’s GDP.  Again, by this ratio, California does not look like one of the worst states. Hawaii, Massachusetts, and Connecticut, all have debt to GDP ratios of over 8%, while California is around 5%.

So, what’s the bottom line?  By these traditional measurement ratios, California does not look as bad as its rating would indicate.

Are California Bond’s expensive?

To understand California’s low credit rating, a lesson on California’s politics and economics is needed.  The following history was explained to me by Bob Donahue of Municipal Market Advisors, the leading independent research firm focused on municipal bonds.

In 1978 California (by public referendum) passed prop 13, which severely limited increases in property taxes, an important revenue stream for municipalities. Partly as a result of not having enough revenues, local municipalities dramatically underfunded their school systems. Worried about the deteriorating conditions of their school systems, California voters passed proposition 98, which required the state provide a minimum percentage of its budget to support the local school systems. As a result of Proposition 98, between 40-50% of California’s state budget is now mandated to go towards public schools. This also means that the politicians in California have relatively little discretion over the biggest expense item on their budget, putting it in a much worse position than most other states when they try to cut spending.

Another reason for California’s low rating is its economic history. California’s economy is full of booms and busts. During the first internet boom that ended in 2000, a huge portion of the companies that went public were based in California. The state saw a major influx of revenues in the form of capital gain taxes. While these taxes were essentially “one shot” or a temporary revenue increase, the politicians increased the state’s expenses as if they were a permanent increase in revenues. California has a long history of not being financially responsible.

Bob Donahue of Municipal Market Advisors also noted that during a previous more severe crisis California was running around a $35 billion budget deficit (twice the current level) and had a smaller economy than they do today. However,  the spread over the AAA yield curve for the 10 year bond during that time only temporarily spiked up to the 85-95 point range,  and then came back down. Now, the spread on California bonds are perpetually near those levels. Essentially, investors want to be paid for the risk they feel is inherent in buying a California bond.

What does Peter Hayes think of California State bonds?

Peter Hayes oversees $106 Billion of municipal bond investments for BlackRock (read our recent interview with Peter Hayes here). Several of these funds specialize in California. The Blackrock  California Municipal Bond Fund (institutional shares, Ticker Symbol MACMX) has an annualized return of  6.56% for the last five years , putting it in the top 1% of California municipal bond funds according to Morningstar.

Is Peter Hayes a California bull or bear? He responded that he believed that California represented favorable relative risk / reward characteristics relative to the market.

Which part of the yield curve does he favor? BlackRock’s general view is that the steep slope of the yield curve provides opportunities on the longer end of the yield curve.

What about California does Peter Hayes like?

  • Large Diversified Economy
  • Positive Changes In Legislative Process
  • High Priority Of Payments To Debt Holders

What about California does Peter Hayes not like?

  • Population Migration Away From The State
  • High Concentration of Wealth  /  Dependence on Volatile Capital Gain Taxes

A 16 Billion Dollar budget deficit sounds extremely daunting. However, Peter Hayes suggested that the headline number is often overemphasized without providing any context. California is the largest state economy with significant technology, agriculture, real estate and tourism industries. With over 1/10th of the United States population living in California, California will generate much larger budget deficits than the other 49 states.

Peter Hayes also believes the diversification of California’s economy and its size are credit positives. He also cited changes to the laws in California as positive for bondholders. Recently, California went from requiring state budgets be passed by ⅔ rds of the legislature to a simple majority. Peter Hayes noted that although passing a budget requires a simple majority, making budget amendments like tax increases, requires the 2/3rds vote and can make long-term solutions difficult to implement.

Last year, California passed the budget on time for the first time in many years. The previous year, the budget was passed 100 days late. Peter Hayes believes that the rating agencies may be penalizing for past bad behavior which might not be reflective of California today.

California General Obligation bondholders have very good standing in terms of priority of payment obligations for the state’s general fund into which the state’s income and capital gains taxes flow. The only obligation that is a higher priority is Prop 98 required spending.

While Peter  Hayes is positive on California, he does see some factors that need to be part of any evaluation of the Golden State. One those factors is that California went from a state that was attracting immigration from other states, to one that has been losing population.  A large portion of those leaving California are also high income individuals who are responsible for a higher portion of both income taxes and capital gains taxes for the state. When discussing the migration issued I asked if he expected the problem to become worse as a result of the Governor’s proposed taxes to address the budget deficit. Peter Hayes answered that he did not expect an immediate mass exodus as a result. He noted that migration was a slow process often involving selling a house and finding a new job.

The other issue that Peter Hayes raised was the state’s revenue mix. He noted that Prop 13 limits the ability of local governments to raise property taxes and requires greater dependency on the state.  Hayes added that the state was far too dependent on personal income taxes and capital gains to solve budget gaps. Capital gains is a revenue stream that is highly dependent on the performance of the stock market. The volatility of the stock market makes predicting future revenue very tricky.

Learn Bond’s Take

There is no reason to panic because California increased its projected budget deficit for 2012 – 2013. While California has some problems, the current spread is almost a full percent over the AAA yield curve. In other words while California municipal bonds are not a screaming bargain, investors are getting compensated for any additional risk.

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