In our most recent “Minute in the Market”, we highlighted the negative headlines surrounding the City of Stockton’s recent bankruptcy filing and the challenges California Redevelopment Agency bonds are facing after the agencies were dissolved earlier in the year. This week has produced further headlines from California municipalities, many of which appear extremely negative, but in all cases refer to very specific situations that have different implications for bondholders, depending on the specific obligor backing the principal and interest payments.
The City of San Bernardino filed for Chapter 9 bankruptcy protection on Thursday, citing an inability to pay city workers on August 15th due to a cash shortage and a large structural deficit. “Reorganization may be the only way to keep the city of San Bernardino on life support,” said a city council member. But like Stockton, San Bernardino’s fiscal problems have been visible for some time. San Bernardino has run large budget deficits for years, and it carries a massive debt load. Stagnant revenues and increasing operating, pension, and healthcare costs, along with rumors of accounting errors, have now pushed the city over the edge. What is interesting from a bondholder’s perspective is that, while the City of San Bernardino has struggled, the Community College District (CCD) of San Bernardino, a separate operating entity not tied to the city, continues to show solid operating performance despite the region’s economic challenges. This, combined with a debt load that is long-term in nature, creates a credit picture that is much different than that of the City. Despite both the City and the CCD being located in the same area, the CCD bonds have much better credit quality due to judicious fiscal management and a very strong structure securing payment of bondholders.
In other community college news, but in a much less reported story (for now), the City College of San Francisco was downgraded by Fitch last week, due to the fact that the school is facing a review from the state Accreditation Commission that may result in the college losing accreditation and being forced to temporarily shut down. On the surface, this story appears to be extremely negative for the college’s bondholders, but in looking at the actual security backing the bonds, the picture is much different. City College of San Francisco’s outstanding bonds are unlimited tax general obligation (GO) bonds, which means that even if the college is shut down (difficult to imagine this actually occurring), the bonds are supported by a voter-approved tax levy that is unlimited as to rate or amount for payment of debt service. The college has approximately $370 million GO bonds outstanding, and annual debt service runs at approximately $30 million. Measured against the district’s fiscal year 2011 assessed valuation (AV) of $163 billion, outstanding debt is only 0.24% of AV, and the annual debt service levy amounts to no more than 1.9 cents per $100 of AV. The risk that the school will be shut down does point to a weakening of the school’s credit quality, as cash flows from operations are called into question, but the security provided by the unlimited tax general obligation pledge should give investors comfort that the risk of default is still quite small.
The recent news in California only emphasizes the complex structure under which many bonds are issued, and the critical importance of understanding what one owns. In San Francisco’s case, we at SNW Asset Management are extremely positive on the debt of the utility system and the airport, but have an unfavorable view and hold no debt issued by the city, county, or the city school district. Although we believe there is no danger of imminent default, the prices of City College of San Francisco bonds could fall substantially if the school is temporarily shut down. Bottom line, we believe that these negative credit events by weak municipalities are just beginning, and we look forward to a period of more widespread volatility in the marketplace as opportunities to add yield in our clients’ portfolios.