Trend in the Region

California on Junk Watch

SAN FRANCISCO — Investors are betting that California will emerge from its current budget crisis with its investment-grade bond ratings intact, but they’re still worried.

Long-term California general obligation bonds rallied this week along with the rest of the market in trading that saw the battered credit’s gaping yield spreads tighten somewhat.

The move came even after Fitch Ratings downgraded the state’s GOs two notches to BBB from A-minus and cut the state’s lease-backed debt to the lowest investment grade, BBB-minus. Fitch warned that it might have to cut the debt further if the lowest-rated U.S. state doesn’t close its $26.3 billion budget deficit soon.

“You’re seeing less selling than one would think. You’re not seeing big institutions dumping the bonds,” said Alexander Anderson Jr., a private client portfolio manager at Los Angeles-based Envision Capital Management Inc. “I think we’re seeing a lot of investors that are holding through it.”

That’s not to say the bonds are trading well.

California’s 30-year bonds yielded 5.92% Wednesday, down from 6.1% last Thursday, according to Municipal Market Data.

 The spread to MMD’s triple-A GO benchmark narrowed to 133 basis points Wednesday from 144 basis points on July 2 just prior to the Fitch downgrade. The spread was just 45 basis points on July 8, 2008.

“The market had priced the downgrade in before the rating agencies cut,” said Dan ­Solender, director of municipal bond management at Jersey City, N.J.-based Lord, Abbett & Co.

California fiscal officials have been issuing warnings and ­begging lawmakers to avert a cash-flow crisis for weeks, but Republican Gov. Arnold Schwarzenegger and Democrats who control the Legislature have been unable to reach an agreement on how to close the budget gap.

Schwarzenegger wants to eliminate the entire deficit with spending cuts, while Democrats want to raise revenue to avoid closing down major social programs.

California Controller John Chiang last week began paying the state’s low-priority debts with IOUs — officially known as registered warrants — to conserve cash for debt service, school aid and other high-priority payments that are required under state law.

Fitch’s action was its third downgrade of California this year, and the agency kept the state’s bonds on negative watch.

Moody’s Investors Service cut the state’s GO rating to A2 from A1 in March and put it on its watch list for a possible downgrade last month. Standard & Poor’s cut its rating to A from A-plus in ­February. It affirmed the rating last week but kept the state on negative CreditWatch.

“With A ratings from the other two rating agencies, I still think these bonds are overrated, given the magnitude of the problems that we have and the cash-flow concerns,” said Dick Larkin, director of credit analysis at Herbert J. Sims & Co.

“It seems fair to put them in the triple-B range at this point,” said Solender.

California’s economy has been hard hit by the recession. Its unemployment rate rose to 11.2% in May, having more than doubled in the past two years.

State revenues, which are particularly volatile because of California’s dependence on capital gains taxes, fell by almost 19% in fiscal 2009 through May, according to the controller.

One of the state’s biggest credit strengths at this point is that its constitution requires the controller to make general obligation debt service the state’s second-highest priority after school aid, which is guaranteed at 40% of the general fund. Payments for lease revenue bonds are ranked lower on the list of payment priorities.

“Default is a very unlikely scenario,” Solender said. “There are a lot of different layers of expenses that have to be cut off before we get to the bond debt.”

“All the bonds will be money-good,” Anderson said. “But in the meantime, it’s driving all investors nuts.”

Fitch said the cash-flow deficit is projected to rise to $16.1 billion in October, and the amount of obligations eligible to be paid by IOUs will shrink to $10.6 billion. At that point, the state would have to begin to pare back some priority payments, eroding bondholders’ margin of safety.

“Margins for meeting constitutional and court-required contractual commitments are narrowing,” Fitch analysts Richard Raphael and Douglas Offerman said in the downgrade report. “After September 2009, absent any proposed budget and payment adjustments, cash deficits will expand dramatically.”

California lawmakers — dogged by a cyclically vulnerable reliance on capital gains taxes and budget rules that require two-thirds majorities to pass budgets and tax hikes —  faced this challenge before.

They always seem to solve the problems when they reach the brink of disaster, according to Solender.

California’s credit rating fell into the triple-B range in 2003, and the state faced a cash crisis until lawmakers and voters agreed to sell long-term debt to finance deficit spending.

Fitch’s Raphael cautions that California is in a deeper and different hole than it was in 2003. In that year, the U.S. economy was growing. The 2000-2001 recession had been over for more than two years, and unbeknownst to policymakers at the time, the state’s revenues were about to pick up.  “The economy and revenues are at a different stage here. Things were stabilizing, if not improving economically” in 2003, Raphael said in an interview. “It’s a different economic environment, and I think that’s important.”

One reason that investors continue to bet that the state’s leaders will act to avert a full-fledged fiscal meltdown — despite the steeper odds this time around — is that the costs of inaction are just too high.

Investors don’t think policymakers will let the state’s credit deteriorate to the point that any of the major rating agencies will cut the ratings to junk.

“I don’t think it will happen,” said Larkin. “But if it did, there would be hell to pay.”

Investors are split on exactly what hell would look like for the Golden State.

Some said big institutional holders would dump California bonds en masse in the event of a downgrade to junk status. Others said funds would try to ride the credit cycle out, pointing out that investment-grade funds are sometimes allowed to hold junk bonds if they were investment grade when they bought them.

But of the investors interviewed for this article, all agreed that rates on outstanding debt would rise significantly, and most agreed California would effectively lose access to capital markets if its ratings fell below investment grade.

Larkin said the loss of California’s investment-grade rating wouldn’t just harm the state, but also would hurt municipal bond issuers across the country.

“If their bond rating goes to junk or goes below investment grade, it would have phenomenal consequences across the entire municipal bond market,” he said. “It would represent a major change in people’s belief in the safety of the municipal bond market.”



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