Ca Muni Market

As a firm we have been invested heavily in California Municipal bonds over the past couple years. As I regularly speak with the managers we utilize, and attend conferences, this is one area that has had a lot of controversy given the problems California is facing. I have just completed another round of conferences about the California Muni Bond market and what follows is a brief summary from what I have gathered from people whom I consider to be the best muni bond managers in the business.

There are plenty of problems happening in California right now and you don't have to look far or dig too deep to find cause for concern. We are just coming out of one of the worst recessions since the great depression and tax revenues are down across the board. To further complicate things, many municipalities have budget deficits and underfunded pensions which need to be addressed. On a smaller scale, there have been a few issuers that made misguided hedges against contracts which generated huge losses and a few small cities which relied heavily on housing and property tax growth to generate the income needed to service their debt. The major issue here is that California is taking in less tax revenue and running budget deficits in many areas.

I know this all sounds bad, but to put this into a more balanced perspective, there are still plenty of reasons to stay in California muni's. First, if you look at this from a historical and statistical perspective, the 10-year cumulative default rate on A-rated muni paper is about  .03% over the last 40 years, which has included several recessions. Another factor to consider is that municipalities are required to place a priority on meeting debt obligations, second only to K-12 school funding. If a municipality were to default on its debt, it would be a catastrophic event which would cause further problems for the issuer to obtain financing and require them to pay higher interest in order to attract investors. Therefore, you rarely see municipalities defaulting on their debt.   Yet another reason is that municipalities have the ability to raise fees or taxes to ensure debt obligations are met. 

Now more specific details for California. California is the 8th largest economy in the world. It is the most populous state, which benefits from a diverse economy and continues to see population growth. California has high tax rates and a very large, very liquid muni market. It often makes little sense for residents to invest outside of the state because the tax benefits are so great. Debt service rates are generally less than 10% of revenue and many municipalities have made drastic cuts in spending to fill budget gaps. Tax revenues appear to have bottomed and recently exceeded expectations. While there are still areas of the market to stay clear of, the negative media headlines have created distortions in the relative value of many California-based issuers and, therefore, many general obligation and essential purpose revenue bonds appear to be a compelling value for California residents.

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