To understand why Josh Gonze likes local school district debt in California, one has to blow the dust off the state’s constitution, which was ratified in 1879.

Article XVI, Section 8 of the constitution requires that state tax revenue must be apportioned to support public schools before it is used for anything else.

Gonze, a Thornburg Investment Management portfolio co-manager, points out the priority of public school districts over the state’s general obligation bonds is thus enshrined into state constitutional law.

One would not know it looking at bond yields in today’s market.

As high as yields on California state debt are — the Golden State came to market with a $6.5 billion bond sale last month with 30-year yields north of 6% — yields on local school districts are often higher. Sometimes much higher.

“Sometimes these school districts are trading as if there was a serious flaw in them,” said Gonze, who works out of Thornburg’s offices in New Mexico.

That is what offers Gonze the opportunity to pick up plump-yielding bonds with priority over state GO debt for his California fund.

California 30-year GOs are trading at 113 basis points in excess of the yield on triple-A 30-years, according to the Municipal Market Data yield curve.

While that is almost triple the spread of a year ago, Thornburg’s California fund has almost no state GO debt.

Gonze said he can find fatter spreads on local school district bonds.

“Sometimes we can buy school district GOs at a cheaper level” than state debt, he said.

For example, he snapped up zero-coupon Oak Park School District bonds maturing in 2030 at a 6.64% yield. That is a 208 basis point spread over that maturity for triple-As on the MMD scale, and a spread of 108 basis points over California debt at that maturity.

This for a bond rated Aa3 by Moody’s Investors Service and insured by Financial Security Assurance. Moody’s rates California Aa2.

“It probably should be something like 50 basis points [in spread],” Gonze said. “If we can buy school district GOs at a wider spread, we’re buying a better bond at a cheaper price. ... This is a better bond, a higher-quality bond, and we’re getting 108 basis points more yield.”

Other juicy deals Gonze recently witnessed include the Murrieta Valley California School District, which at a maturity in 2020 traded at a spread of 181 basis points to the triple-A scale.

Another example is the Escondido School District’s zero-coupon bonds maturing in 2013, which traded at a yield of 4.9%, a 333 basis point spread to triple-A bonds on the MMD yield curve.

“That’s nuts,” Gonze said.

Gonze looks for California school districts rated single-A or better with annual reserve balances of 5% or more.

The portfolio manger also prefers a district to have some cash, even if it’s only enough to cover operating costs for 25 days or so.

Another important factor is local real estate values, since schools finance themselves with local property taxes.

While he recognizes the property market is suffering across the state, “there’s a very large difference between Los Angeles County and San Bernardino.”

California school districts’ bonds are liquid and trade often, and Gonze said he would not expect them to be difficult to sell if he had to.

Gonze co-manages six municipal and three taxable funds with collective assets under management of about $3.5 billion.

Previously, Gonze rated corporate bonds for Standard & Poor’s and then worked in corporate banking at Toronto-Dominion Bank before joining Thornburg in 1999.

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