The California secondary market remains mostly steady to strong as high-profile local municipal bankruptcies unfold, but it has not been without some minor turbulence, according to muni experts.
Spreads on some credits have tightened remarkably in the last month as the cities of Stockton, Mammoth Lakes and San Bernardino either filed or moved toward bankruptcy, but there has been some sporadic weakness as wary investors keep their distance from what they feel is a worsening situation.
“Anecdotally, I’m hearing that people are putting all California credits into one bucket and saying there is going to be credit distress indiscriminately,” said Eric Friedland, director of municipal research at Schroder Investment Management in New York City.
Dan Heckman, senior fixed-income strategist at U.S. Bank Wealth Management in Kansas City, said the California market continues to show signs of strength despite the latest headlines.
They include the San Bernardino City Council voting for an emergency bankruptcy to help cure its $45 billion budget deficit, and reports of serious financial trouble in Fresno and Compton.
Heckman said California is currently sharing in the strength of the overall municipal sector, which has seen steady to lower yields in 23 sessions. Wednesday saw the 30-year triple-A bond fall one basis point to 2.79%, after eclipsing the previous record of 2.80% set Tuesday, according to Municipal Market Data.
In addition, the weekly average yield to maturity of The Bond Buyer municipal bond index, which is based on 40 long-term bond prices, declined eight basis points to an all-time low of 4.31% last week.
Meanwhile, yields on California 5.25s of 2029 dropped three basis points to 3.22% on July 20, according to data provider Markit.
“California bonds rallied right in line with the broad market. There was modest California weakness in late May following a wider than expected budget deficit due to a revenue shortfall, but the Cal market has fully recouped that,” LPL Financial market strategist Anthony Valeri wrote last week in his weekly Bond Market Perspectives report.
“San Bernardino news is not symptomatic of the broad municipal bond market,” he wrote. “The news raised fears of an acceleration in defaults in the municipal bond market, but we do not think this is the start of a domino effect.”
But Friedland said bonds in some sectors are widening because of a general view that all California credits are in trouble.
“Already we have been able to pick up value on credits trading wider than they normally would be,” he said late last week. “There have been a few, which leads me to believe that there will be more opportunities.”
Among recent opportunities, he cited large essential-service retail electricity providers with good debt-service coverage as well as school districts near Los Angeles that are rated double-A, but trading closer to a single-A.
On Monday, an $80,000 block of San Bernardino County certificates of participation traded at a 6.41% yield, which was up from a 5.91% on Friday when a $25,000 block of COPs traded, according to daily trade data on
“The headlines from California are getting uglier by the day, so headline risk may threaten California municipal bond prices,” Richard Larkin, director of credit analysis at Herbert J. Sims, wrote in a report last week.
“For intelligent investors, the California market will continue to offer bonds issued by well-run local governments,” he said, adding that those securities could provide “attractive bond opportunities in the choppy waters ahead.”
In the meantime, double-A California credits in 10 years have tightened 10 basis points on average in the last month, to about 74 basis points over the national triple-A scale, according to Heckman.
He said he has witnessed select credits trading between nine and 25 basis points tighter — and some even tighter — in the last month than before the spate of bankruptcies began.
For instance, Heckman said double-A-rated Los Angeles general obligation bonds with a 4% coupon due in 2017 traded on July 18 at a yield of 0.96%. That was nine basis points tighter than where they traded on July 2, while single-A-rated California GO bonds with a 5¼% coupon due in 2038 traded at 3.08% yield July 17, after trading at 3.33% on July 9.
“The market in general is not that concerned at this stage,” Heckman said. “If you are looking for opportunities off of the headlines of these bankruptcy announcements, we are not getting that selling pressure to come in and take advantage of any spread-widening — we’re actually getting spread contraction.”
“Some of the California paper you would think would be impacted has not widened out enough to make them attractive,” he added.
For instance, bonds from the San Bernardino School District with a 5% coupon due in 2028 traded at a 3.80% yield on July 13, a whopping 55 basis points tighter compared to where the single-A-rated bond traded just two days earlier.
The school district is completely distinct from the city government.
Valeri said supply and demand in California is a bigger driver of prices than the impact of bankruptcies, while the strength in Treasuries continues to foster municipal demand overall.
Likewise, Heckman noted that the record $165 billion of refinancing volume and record $16.5 billion of positive flows into municipal mutual funds for the year to date are helping to buoy both the state and national markets.
The refinancing volume “is putting back into the hands of investors hundreds of millions of dollars,” while the mutual fund flows are evidence that investors “are dumping it back into the market and driving yields down,” he said.
Despite the sporadic widening, Friedland balks at the theory that the latest bankruptcy filings will lead to widespread stress.
“Those that have been municipal analysts for a long time realize that California is a diverse state with micro-economies and many types of issuers,” he said.
“Every municipality around the country is facing an economic challenge. The key to performing well is, how have managers acted during this period? Have they budgeted conservatively and forecasted reasonably? Those that have will come out OK, and those that haven’t are going to be under the most distress,” Friedland said.
Others agreed that the situation will be confined to California, with little effect on the national market.
“I don’t believe that this is the beginning of a tidal wave of city insolvency across the country,” Larkin wrote in his report.
He does predict a rise in municipal defaults — but not more than $20 billion in any one year, which is about one-half of 1% of all municipal bond issues outstanding.
“More bankruptcies, like that of San Bernardino, will continue to make headlines over the course of 2012, but we expect these cases to be isolated events,” Valeri wrote in his report.
Experts said Stockton and San Bernardino, like Vallejo, Calif., which filed for bankruptcy in 2008, share a common credit profile in that they are inland areas that experienced dramatic housing expansion and housing busts during the recent recession.
“They experienced housing expansion, but not necessarily business expansion; they were a cheaper housing alternative, but never became employment centers of their own,” Friedland said.
“The market is differentiating between inland and coastal communities — to our surprise we really have not seen that much spillover effect from a widening standpoint,” according to Heckman of U.S. Bank.
Going forward, he said, the current tone of the California market could be affected by the outcome of the upcoming November tax ballots, or by high foreclosure rates that could contribute to additional bankruptcies.
But LPL’s Valeri believes even that shouldn’t rattle the market.
“More bankruptcies, like that of San Bernardino, will continue to make headlines over the course of 2012, but we expect these cases to be isolated events,” he said.
Friedland agreed.
“You have to be careful, but there will be more entities that will perform adequately than those who will file bankruptcy or be under severe distress,” he said. “It’s not as if these credits that were performing well over the past year tomorrow are deciding to file.”
