Would You Buy California Debt?

Jan.18.10 | About: BlackRock California (BZA)

I asked a fellow investor, and a gentleman I have great respect for, if he would invest in California Debt and if so in what timeframe. He replied that he would not. I am going to attempt to make the opposite case.

First two caveats:

  1. I would be selective in the particular instruments and the timeframe I would invest in.
  2. I would not invest widows and orphans fund money. For the sake of this I will stipulate that I would invest with money I would normally invest in other Municipal Debt.

The Case Against:

  • California has as bad a problem with residential real estate as any state in the country with a 20% increase in mortgage defaults in 2009. (CA along with FL, AZ, and IL are responsible for 51% of the nations defaults).
  • It’s Civilian Unemployment rate for November 2009 was 12.3% versus 10.0% for the nation as a whole. And this is predicted to remain constant through 2010 (per CA dept of Finance)
  • Total Wages and Salaries declined in 2009 to below 2007 levels
  • It’s CPI is higher than the national average
  • Large budget shortfalls for 2010

This is certainly a pretty bleak picture and there are many more things one can point to in the case against the debt of California. Here is a link to a PDF put out by the California Dept of Finance entitled “California at the Brink of Financial Disaster”. When your own Dept of Finance entitles a presentation thusly, things are pretty bad. Financial_Disaster-Presentation-w

The Case For:
Below is page 4 of the aforementioned presentation. I put this up to note the second item in the “Will Pay” column.

As indicated, the state is committed to paying off the General Obligation debt.
There are still many investment grade Muni Bonds issued by California and Tax Districts inside California. The current environment has pushed the yield of these bonds well above the national average.
There are more than 15 million registered voters in California, with the Democratic party having the largest share by a wide margin. In my opinion the current Congress is unlikely in the extreme to let the largest state in the country (by total population and registered voters), who have supported the Democrat party in national elections since 1992 default on it’s debt.

So what would I invest in, for how long and Why?

  • Bonds of aa2 or AA or higher and Insured
  • I would be looking at the 2-3 year timeframe simply due to the belief that towards the end of that timeframe we will be entering into a higher interest rate environment and I want to avoid interest rate risk.
  • I would not buy any bond callable during that holding period other than make whole calls
  • I would be looking at General Obligation, Necessary Services such as Electric and Water Utilities, and Public Education.
  • I would mediate my risk by examining the economic condition of the issuing entity thoroughly.

First let’s look at the comps:
The 2 year U.S. Treasury is currently yielding .96%
The advantage of UST’s is they have the lowest risk of any investment
A 2 year Bank Certificate of Deposit is yielding around 2.05%
CD’s have the disadvantage of illiquidity
Nationwide average yield for 2 year Municipal Bonds is AAA 1.00% AA 1.44 A 1.51

I did a search of current offers where at least $25,000 worth were on offer using the above criteria and came up with many hits. Average yield to maturity (feb 2012 to feb 2013) was 1.5% with a range of .77-2.7% nearly all of which were insured. If one can get 50-100bps above a comparable instrument it seems prudent to examine it.

If you’re a Muni investor, California Municipal Debt is worthy of your consideration here because fear has made the yields attractive when compared to the debt of other states. I do not think I would reallocate from other asset classes into Municipal debt in the current economy on any time frame, but I would reallocate from the Municipal debt of other states to gain the additional yield.

Additional Considerations:
While California Municipal Bonds are Federally Tax advantaged they are probably not in your state, the difference in after tax yield may be a mitigating factor.

Disclosure: The Author holds positions in California State Municipal Debt as well as the Debt of other entities within California.