California's Budget Crisis and Its Impact on Muni Bonds

Rob Williams
Director of Income Planning, Schwab Center for Financial Research
August 5, 2009

Key points

California finally passed a budget—but problems don't end with a budget in place.
Municipal governments may be in for a tough stretch, but they're resilient as long as there's political will to balance budgets, and market support for cash-flow needs.
For investors in individual munis, we offer guidelines for different types of muni bonds and issuers.

On July 29, California legislators passed and the governor signed a new budget, covering a $26 billion shortfall on $100 billion in expenditures with deep cuts, accounting shifts—and Band-Aids. The state still needs to borrow money in short-term bond markets to fund short-term cash-flow needs, and the problems don't end with a budget in place.

California is dysfunctional in many ways. But the fact that a budget did pass, despite painful cutting across nearly every constituency, shows that states take their debt obligations very seriously.

Is this a turning point for California, and a wake-up call for municipalities nationwide? The cover story in the July 26 Barron's makes this case, crediting the "Terminator" (Gov. Arnold Schwarzenegger) with a "signal victory," as he called the bluff on social service costs by "threatening to push California to the brink of insolvency."

Whatever your personal view, we don't see a long-term fix in this budget. But does it matter to bondholders?

Many municipalities face budget problems—but they're resilient. The balance between state and local government expenditures isn't likely to repair itself overnight. While protections remain strong, wise investors will focus on the strongest issuers—especially investors concerned about volatility in price and an adequately diversified municipal bond portfolio.

What does this mean for muni bond investors (politics and opinions aside)?
Politics is the wildcard that complicates discussion with munis. But during the California crisis, even with all the politics, there was no discussion by state officials about default on state general obligation bonds. We laid out some of the reasons why in earlier commentary.

Still, yields on California bonds are higher than other states for a reason. The obstacles don't end today, nor will news of cuts, lawsuits and other challenges. If you do choose to invest in individual-issuer munis, higher yields may be the indicator of higher volatility in value, if you need to sell before maturity.

The first chart below shows this spike in California muni spreads—the difference between yields on California bonds and an index of national AAA general obligation (GO) bonds. The second chart shows what this change in spreads (or yields) means to a decline in price, for existing bonds below par.

California state GO yields compared to national AAA GO index
Chart: California state GAO yields

Source: Bloomberg, Moody's, Fitch, Standard & Poor's.

California state 20-year GO: current price per $100 in original par
Chart: California state 20-year GO

Source: Bloomberg, selected maturity California GO 04/02/2029.

If this drop in value is something you can stomach, it makes sense to consider California bonds and other more "news-sensitive" bonds as part of your fixed income portfolio. We think the protections are extensive.

We don't believe it makes sense under any circumstances to put all of your eggs in one basket. If you're particularly concerned about a dramatic and unforeseen "black swan" event, or the spillover effects of budget problems in any single state, choose a national fund rather than a state-specific fund.

Also, if you work, own real estate, and invest in local bonds in your own home state, your financial profile has a significant geographic concentration. We think it makes sense to diversify with a national muni fund for a portion of your muni portfolio.

What happens now that a budget is in place?
With a budget in place, California's state treasurer will still need to sell short-term notes—also called revenue anticipation notes, or RANs—to help with the state's cash-flow crunch. Tax revenues flow in late in the fiscal year, during the spring, while expenditures are more evenly spaced throughout the year. The passage of a budget makes RAN issuance easier.

However, the recent budget cuts are far from a long-term structural solution. Costs continue to mount, including those agreed to by voters, such as guaranteed school funding levels, mandatory sentencing laws for prison inmates and infrastructure improvements such as high-speed rail. These costs, and others tied by strong contractual protections (such as union contracts with rising benefit and retirement costs) are not easily reversed.

While there are signs that the economy is improving, municipal revenues don't tend to turn quickly. Few analysts expect it, but California might see a bounce faster than others, especially local municipalities that rely on property tax revenues.

The state's primary revenue sources, as with most states, consist of income and sales taxes. In California, income taxes rely even more heavily on capital gains for the wealthiest, highest-income residents. As for sales taxes, there's little evidence that retail spending in the Golden State, or nationwide, is poised to turn the corner quickly.

Despite these challenges, the state controller, treasurer, legislature and governor will continue to have the legal obligation to keep making debt payments, no matter the political popularity of any more-discretionary program.

Political will, however, is a key component in varying levels of market confidence in muni bonds. If politics swung against the legal commitments to pay bonds, bondholders have legal recourse both through bond covenants and the state constitution. Even if insolvency looms, under current bankruptcy law, bankruptcy is simply not an option for a state. Payments would almost certainly be made immediately, as soon as revenues are available.

This level of protection differs from the pledge to bondholders in other high-profile corporate crises such as Lehman Brothers or General Motors. It doesn't eliminate the risk altogether, but provides comfort that risks are contained.

I own California GO bonds—should I sell them?
We generally always advocate diversification. For investors with a concentrated position in California GO bonds, consider how much exposure you're comfortable with, regardless of current prices.

Here are a few guidelines to keep in mind, depending on your investment objectives:

Investors seeking maximum safety. You absolutely must be able to count on return of your principal in full, stable income payments and limited price volatility should you need to sell. While we don't think the state will default, changing news and the lower margin of safety resulting from the budget crisis means California debt is not risk-free. Consider limiting additional investments in California GO bonds and diversifying into other more highly rated munis or US Treasuries.
Traders worried about price fluctuations and investors looking for relative value and possible trading opportunities in downtrodden muni credits. Right now, the spread between the yields of California munis and other comparably rated muni bonds are at their highest levels in recent history. Bond markets also tend to be very good at pricing in risk or market news well in advance of changes in bond ratings.

During California's last credit crisis in 2002, bond prices actually rose steadily after rating downgrades from several major firms—and the same thing happened during the recent crisis. The bad news had already been priced in, and prices have begun to recover now that the budget has passed, though ratings haven't changed.

The past is no guarantee of the future, however. Traders need to be aware that, in the event the news flow remains negative, California bonds are likely to remain under short-term price pressure.
Buy-and-hold investors. Your primary concern is that interest payments continue to be paid on your bonds and that your principal will be repaid in full at maturity. Because you're holding for the long term, you can accept short-term price volatility.

If I don't believe California will default, is now a buying opportunity?
As with any investment decision, this depends on your individual situation. Yield is the price markets put on risk, whether on price volatility or outright default. Yields generally rise when concerns are highest, and also fluctuate based on supply and demand. The risk in munis comes primarily from volatility in price before maturity, and relative "margin of safety," as opposed to outright risk of default.

Investors are also increasingly aware of "tail risk"—that is, the risk of an extreme, unexpected event—especially given recent, unprecedented troubles in credit markets overall. While not expected, an extreme event is impossible to rule out completely.

Regarding bond ratings, changes in ratings have often been preceded by changes in bond prices. As we know from recent high-profile events in corporate credit markets, they're slow to react, and are not a guarantee of long-term credit quality or fluctuations in bond price. We recommend you use them as part, but not all, of an investment decision.

Regardless of your confidence (or lack thereof) in ratings, this point is certain: The margin for error is lower for issuers with budgetary problems. This is generally reflected in bond ratings. If your investment objective is absolute security, then Treasury bonds or higher-rated municipalities are probably better options.

Are other types of California bonds affected by the crisis?
Yes. The two main additional types of state debt are lease revenue bonds and economic recovery bonds (ERBs), and there are other types of public works and dedicated infrastructure bonds.

Lease revenue bonds are secured by state leases on a variety of state properties and facilities. Their payment comes after both education expenditures and payments on GO bonds, and at the same time (according to bond documents) as state employee wages, contributions to the state pension funds and state Medi-Cal health care claims. They carry lower bond ratings and are less secure than state GO bonds.
ERBs are secured by a dedicated state sales tax, with back-up support from the state general fund. They rely on the strength of sales tax collections, coverage on debt payments provided by those taxes, and other legal protections. The rating on these was downgraded recently as well, however, due to declining sales tax collections.
California state public works and other types of state infrastructure bonds or financing authorities can vary, but are generally secured by a mix of state or state-department leases on buildings, or other revenues. These are not always direct obligations of the state general fund, so funding sources can vary. It's helpful to read a prospectus for the bonds to understand if there may be unique risks involved.

GO bonds issued by school districts, cities, counties and other local issuers
What about local California bond issuers, like school districts, cities, counties and others? Are some local issuers more protected than others?

GO bonds are considered the strongest, broadest security pledges available for municipalities. They include the "full faith and credit" pledge of the issuer, from any legally available sources. This includes, in many cases, a voter-authorized property tax used only to pay back bonds. This is also true of GO bonds in any state, not just California.

In the event of bankruptcy—possible for local municipalities under Chapter 9 of the bankruptcy code—bond payments can be interrupted by a bankruptcy court. However, these events are so uncommon that legal precedent is unsettled. In at least a few of the recent cases, troubled municipalities have continued to make bond payments, even in bankruptcy.

Here's a closer look at different types of locally issued GO bonds.

K-12 school district GOs
K-12 school districts are heavily reliant on state funding and are on the front line in the debates about budget cuts. GO bonds, however, are secured by local property taxes, authorized by local voters and carved out explicitly for debt service payments.

GO bonds in California must be approved by local voters. For schools, a dedicated property tax to pay bonds is limited initially to a relatively low maximum tax of $60 per $100,000 in taxable assessed value for unified school districts, $30 per $100,000 for elementary or high school districts and $25 per $100,000 for community college districts. If the tax collected isn't sufficient, the district is obligated to pay from other sources and increase the marginal tax the following year to make sure that bonds can be paid.

K-12 school districts are also controlled by very strict financial oversight both by county boards of education as well as the state superintendent's office. Where there have been severe budget stresses, K-12 districts have been taken over by the state temporarily, their local school boards removed from power, and loans advanced until a longer-term solution is developed under a state-appointed administrator.

During the past 30 years, no K-12 district has defaulted on investment-grade rated GO bonds. Examples of high-profile state takeovers have included the Oakland Unified School District and the West Contra Costa School District.

Due to these features, we believe that California K-12 school have significant administrative backstops in place to make default on GO bonds less likely, above and beyond formal bond protections, and despite ongoing budget pressures.

City GOs
Cities in most states rely to a degree on state support, but less so than most other local jurisdictions. They have greater revenue-raising ability at the local level, through fees and other charges, and fewer state-required and state-funded service obligations.

However, they're vulnerable to "take-aways" of local revenues by the state, a remedy pursued in the past and in the current budget to help with state-level problems. But they generally have more tools to adjust than other local municipalities.

Their local economies, and service needs, however, vary more widely. The weakest and most economically compromised do face significant budget stresses. These include declining local property and sales tax revenues, as well as rising (and contractually guaranteed) costs.

Due diligence is required here, and try to limit exposure to any single issuer. The highest-rated and most-affluent cities will generally be in better position to meet bond-payment obligations.

County GOs
Counties in California face the stiff headwinds of a slew of mandated services—such as indigent health care, social services, and other expensive service obligations—that are not well-funded but still legally required. They rely heavily on state funding to provide these services and have less revenue-raising ability than California cities.

Counties also have a more difficult time securing voter support for GO bonds or tax increases, due to their larger jurisdictions and less-popular service obligations. As a result, they're often issuers of "lease-revenue" bonds, also called "certificates of participation," or COPS. We'll discuss those below.

While they're less frequent issuers of GO bonds, we believe counties are heavily exposed to the crunch of service pressures and budget cuts. They generally adjust with service cuts, but different counties will vary in their flexibility and response.

Other local GOs
There are a variety of other local municipalities and special service districts that issue GO bonds. If you hold these, be sure to read the prospectus to understand how much exposure any might have to state budget problems.

Lease-revenue bonds (also known as certificates of participation, or COPs)
All of the local municipalities mentioned above can also issue lease revenue bonds to fund infrastructure needs. COPs are secured by a municipality's pledge to make lease payments for use of various government properties. The leases are renewed annually, at the municipality's discretion. If the leases are not renewed, a trustee must repossess the property and either re-lease or sell for the benefit of bondholders.

Municipalities issue COPs to maneuver around state constitutional requirements that require a local vote for any long-term bond obligation that spans more than a single fiscal year; the renewable lease provision allows them to get around this restriction. COPs are also not secured by a local property tax collected solely for the purpose of making bond payments.

Ratings are lower than those on GO bonds, but defaults or non-renewal of leases are equally rare. Still, during periods of severe budget stress, we consider these to be less-protected, and more at risk, compared to local GO bonds.

Essential service revenue bonds
These include water or sewer service revenue bonds, secured by local fees for water or sewer (or other) essential services. These issuers are typically less reliant on state revenues and budgets to support bond payments. The more essential the service, generally, the more predictable revenues are likely to be to support bond payments.

We believe water/sewer and other essential-service revenue bonds in the highest rating categories (AA-/Aa- or higher) are relatively secure investments and a good way to diversify away from more state-sensitive muni bonds.

Other tax-exempt revenue bonds (higher-education, transportation, healthcare)
These types of revenue bonds are secured by revenues from a particular public enterprise, like a hospital, airport or university. Along with water and sewer revenue bonds, they make up roughly half of total investment-grade muni bond market. The protections will vary, as well as the reliance on state revenue support to provide those services, if any. They're also more exposed, frequently, to local business risks.

Read the prospectus carefully so you're comfortable with the particular revenue source and any risks involved.

Tax allocation bonds (TABs), community facilities districts (CFDs) and other special revenue and infrastructure development bonds
These bonds are generally secured by local property assessments, levied either on a per-parcel basis or as a percent of the assessed. These securities can be quite complex, and liquidity/market demand can vary. Also, one of the "fixes" in California's budget has been a "take-away" of revenues from many redevelopment tax allocation districts, which could impact revenues available to pay on TABs.

We encourage you to make sure you understand what revenues are pledged and do the due diligence required to make sure you're comfortable with the risks of any particular security.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Fixed income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications and other factors.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment purposes only and not intended to be reflective of results you can expect to achieve.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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