Standard & Poor’s downgrade of California last week raises a crucial question: does the Golden State’s debt at some point become no longer appropriate for conservative retail investors?

“California will honor its obligations, but it will take us on a roller-coaster ride,” said Tom Dalpiaz, a portfolio manager at Advisors Asset Management. “You have to recognize that if you invest in California state GOs, it’s going to be a roller-coaster.”

With $63.9 billion of outstanding general obligation debt, California borrows more than any other state.

California also gives investors more ulcers than any other state.

Since 1990, Standard & Poor’s has changed California’s rating 13 times.

In one span early last decade, the state’s rating plunged to triple-B from double-A in barely more than two years.

The yield on 10-year California paper has ranged from 73% of the 10-year Treasury to 241% of the 10-year Treasury since 1990, according to Municipal Market Data.

That is more volatile than the municipal-to-Treasury ratio range on bonds issued by Pennsylvania or New York — or, for that matter, generic triple-A rated municipals.

The budget for fiscal 2011 that Gov. Arnold Schwarzenegger released this month holds little promise for tranquility. The state faces a deficit of nearly $20 billion, having just closed a $60 billion gap last year.

Schwarzenegger warned closing this deficit will probably be even tougher than closing the last one.

The state has chopped spending on health services, transportation, and housing, and revenue is still anticipated to be inadequate to cover $118.8 billion in proposed spending.

Heavily reliant on income and sales taxes, California collected less tax ­revenue last year than it did in 2005. Taxable sales receipts shriveled 15.6% in 2009, and personal income in the state has been stagnant the last three years.

The state last year issued IOUs in lieu of tax refunds and payments to vendors, and had to float revenue anticipation notes to ensure sufficient cash flow.

In his report last week, Standard & Poor’s analyst Gabriel Petek said the downgrade to A-minus from A reflects a “severe fiscal imbalance” and an impending cash deficiency.

The state largely resorted to temporary — or as the governor called them, “not available on an ongoing basis” — solutions to plug last year’s budget gap.

Standard & Poor’s did not rule out another downgrade in the next six months to a year.

Despite all the bad news, few analysts expect California to default on its bonds.

The cost of repaying debt this year is $6.22 billion — 7.5% of general fund revenues.

Further, the state constitution requires bondholders be repaid before nearly any other expense can be covered, with the exception of school funding.

Nevertheless, there may be a point where retail investors in the normally staid municipal bond market grow ­weary of reading these kinds of ­headlines.

The yield on California’s 10-year GO debt is about 145 basis points higher than the yield on triple-A munis based on the MMD scale.

California’s bonds are still appropriate for retail investors, Dalpiaz said, provided investors understand that those 145 basis points are not free.

Default is not the only risk in bond investing, he said. Investors are exposing themselves to greater price volatility in exchange for that spread.

The volatility the spread compensates for is reflected in the spread itself.

Since the mid-1990s, the spread has gyrated from as low as 34 basis points in 2000 to as high as 192 basis points last year.

The spread has bounced around with a standard deviation of 37 basis points. Pennsylvania’s spread, meanwhile, has fluctuated with a standard deviation of only four basis points.

The lower volatility is one of the reasons Pennsylvania’s spread is less than 20 basis points now.

Alexander Anderson Jr., a portfolio manager with Envision Capital Management, said he has shifted some of his clients’ money out of California and into other bonds.

Not all his clients have the tolerance for that kind of turbulence, he said.

“It all depends on your view of risk,” he said. “Traditionally, municipal bonds are seen as a conservative investment. As California continues to have its financial problems with no end in sight, the question is whether it’s an appropriate conservative investment for retail investors.”

Not all investors have someone like Anderson or Dalpiaz managing their money. Many retail investors rely on vehicles like mutual funds to gain exposure to municipal credit.

The data shows many of these vehicles offer a bulwark against volatility. Take Franklin Templeton, which operates two of the biggest municipal mutual funds: the $10.6 billion Franklin Federal Tax-Free Income Fund and the $14.2 billion Franklin California Tax-Free Income Fund.

Since 2000, the weekly changes in the price of A-class shares of the national fund have exhibited a standard deviation of 0.73%. The California fund’s A-class shares’ standard deviation is hardly much higher, at 0.79%.

Still, the roughly $49 billion in mutual funds devoted to California’s debt had a much rockier year in 2009 than the general municipal fund industry.

While California funds attracted about $785 million from investors in 2009, they were bleeding money for much of the first half of the year.

Mutual fund inflows have pulled back a touch in the past few months from the dizzying high level seen in the fall.

The latest data from Lipper FMI shows a possible pickup.

The $469 billion municipal bond mutual fund industry reported $733 million in inflows among funds that report their figures weekly for the week ending Jan. 13.

Among all funds, inflows have averaged $1.2 billion a week for the past four weeks.

“Weekly muni mutual fund inflows ticked significantly higher from last week’s anemic levels,” said Chris Holmes, municipal strategist at JPMorgan.

California, high-yield, and long-term funds led the way, Holmes said.

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