California Bond ETF Holders Should Beware

Includes: CMF, CXA, MUNI, PWZ
by: Anthony Alfidi

California is the Golden State. Its credit rating, unfortunately, is not so golden. Its general obligation bond rating is the lowest in the nation and has shown a steady deterioration throughout 2009. How did this happen? A recent article outlines the unfolding tragedy:

Federal law prohibits states from declaring bankruptcy and without a legal framework, assertions about California's solvency are left to interpretation. But persistent multibillion-dollar budget deficits, cash crises, tens of billions of dollars in debt and other obligations have blurred the legal distinction.

Over the next 16 months, the state has a $20 billion deficit in the general fund budget. That's the equivalent of nearly a quarter of the current spending plan of $84.5 billion. Much of that spending is locked in because of voter initiatives and federal mandates, limiting options for lawmakers. The deficit this year is more than the state spends on higher education and prisons combined.

The state's pension fund, CalPERS, has $16.3 billion more in liabilities than assets at the latest calculation, although that number fluctuates with the system's investment portfolio. Adding to that, a state report released this month calculated that California also faces a $51.8 billion bill - in 2009 dollars - for the health and dental benefits of state retirees and future retirees.

The Governator's plan to balance his state's budget in 2010 relies heavily on a federal subsidy of $6.9B. There is no assurance that this subsidy will be forthcoming in an era when one of every three dollars in federal spending is itself borrowed from the bond market. Note further that the non-partisan Legislative Analysts's Office has published a pessimistic analysis of proposals to reduce the state budget deficit. The LAO assesses a significant part of the Governator's "trigger proposal" estimate to be unreconcilable; it further assesses many business subsidies and tax exemptions as ineffective and unjustifiable. This sets the stage for further political wrangling and puts the passage of a balanced budget for 2010-11 at risk.

The excerpted article above notes further down that the state's net assets exceed its net liabilities by $34B. If the state is unable to resolve its budget crisis, would it sell state parks and government buildings to pay its bills? The Governator floated just such a trial balloon last year, probably as a political ploy to force a budget solution. A budget crisis this year may see such proposals become reality.

The risk to California muni bond investors from prolonged budget inaction is significant. In addition to individual and pension plan holdings of Cal munis, three ETFs hold state bonds - PowerShares Insured California Muni Bond (NYSEARCA:PWZ), SPDR Barclays Capital California Muni Bond (NYSEARCA:CXA), and iShares S&P California Muni Bond (NYSEARCA:CMF). The ETFs hold about $290mm worth of munis, all with medium to high interest rate sensitivity. Any further downgrades to California's credit rating will raise the state's borrowing costs, posing an immediate risk to holders of those ETFs.

Disclosure: No positions in California municipal bonds or ETFs mentioned.

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