California Bond Market In Focus

The California municipal bond market has been in the news on numerous occasions in recent weeks, with the passage of a balanced FY2013 budget being the main headline.  This agreement highlights the benefits of a 2010 voter-approved ballot initiative that allows legislators to pass a budget with a majority vote, rather than the two-thirds supermajority previously required.  While the budget allows the state to avoid last-minute negotiations and I.O.U. issuance, it is highly dependent on a proposed tax increase for the wealthy, which will be voted on this fall.  If the tax hike is not passed, severe cuts in state funding will be handed down to entities ranging from school districts to long-term care programs.

As the state continues to struggle fiscally after years of mismanagement and pressure from the economic downturn, certain cities in California are facing more immediate pressure.  The City of Stockton, for example, recently filed for Chapter 9 bankruptcy after arbitration talks with bondholders and labor unions failed, making it the largest US city ever to file for bankruptcy.  Declining property tax revenues caused by the real estate downturn, coupled with mounting retiree costs and huge spending on a downtown revitalization effort, forced the action.  Despite spending cuts of more than $90 million since 2009, including a 25% reduction in the City’s police department and a 30% reduction in fire department services, the seemingly never-ending budget deficits proved too great.  The City’s finances have been in dire straits for some time, however, making the situation avoidable from a bondholder perspective if one had studied the annual financial statements.

In a less reported but equally transparent bondholder story, California redevelopment agencies have also gone through changes recently. Last year, as part of Governor Brown’s attempt to deal with budgetary shortfalls, the California legislature approved a plan to shut down urban renewal/redevelopment agencies throughout the state and divert certain reserves and other assets to the state for the benefit of public education and other favored purposes.  The legislation took effect earlier this year and has triggered at least half of a dozen defaults on bonds previously issued by the agencies.  Payments were disrupted recently in Monrovia, in Los Angeles County, and Hercules, near San Francisco.  The legislation has had its greatest impact on unseasoned bonds, as the renewal/development projects they financed have not had time to generate incremental tax revenues sufficient to provide adequate levels of debt service coverage or reserve balances.

SNW Asset Management has long been wary of redevelopment agency bonds (also known as “tax increment” bonds) in California, due both to certain long-standing unresolved structural and legal issues and to the magnitude of the state’s fiscal crisis and the resulting degree of desperation underlying some of the proposed budgetary palliatives.  The state’s recent action is dismissive of bondholder interests in the worst-hit credits, and it strikes us as short-sighted and damaging to the state’s longer-term interests in being able to access the credit markets.  Unfortunately, it justifies our practice of using caution with respect to this type of financing in California, as the legality of bond payments was structured differently in California than in other parts of the country.  While not every such issue in California will default, and while similar bonds issued in other states with less pressing financial problems are often satisfactory credits, we often take pains either to avoid genres of suspect credits entirely, or to buy them only after very rigorous appraisal of their underlying structure and intrinsic creditworthiness.

The fate of all too many California urban renewal/redevelopment bonds, along with those of the City of Stockton, once again shows the value of the kind of careful credit reviews we undertake before adding bonds to our clients’ portfolios.  We think you’ll agree that it is better, in these types of situations, to forego a bit of yield by being careful about acquiring or monitoring bond holdings than to run the risk of incurring the kind of loss of principal that now faces many investors in certain California municipal bond issues.