Petruno Says That The “Rebuild California” Bonds Won’t Hurt Existing State of CA Debt

A couple weeks ago, regarding the so called “Rebuild California” propositions and their effect on outstanding state of California debt I wrote:

If you are an owner of State of CA municipal bonds, as many people are because the interest is free of state taxes, the issuance of more bonds hurts your investment.  As California takes on more debt, increasing its financial strain the likelihood of its having difficulties in paying back existing debt increases.  This leads to a lower credit rating and lower bond prices.  If these bonds pass expect California’s existing bonds to take some kind of a hit. 

According to an excellent article by the LA Times superb business columnist Tom Petruno in today’s LA Times, the hit might not amount to much:

The official line from the major bond rating firms is that California can easily afford the five statewide bond measures on the ballot. 

‘The state’s overall debt burden is likely to remain manageable,’ said Douglas Offerman, who watches California for Fitch Ratings in New York.

John Wiley, co-manager of the Franklin California Tax-Free Income mutual fund, one of the largest municipal bond funds, says he’s losing no sleep over the prospect of a mountain of new state debt that could, in theory, depress the value of outstanding bonds over time. 

As for the state’s ability to handle the debt that the ballot propositions would authorize, there is one main barometer that Wall Street considers: the percentage of state revenue consumed by debt service, meaning interest and principal payments due on bonds outstanding.

Infrastructure-related debt service ate up 4.2% of the state’s revenue in the last fiscal year.  If all of the previously authorized debt is issued, and all of the bond propostions on Tuesday’s ballot pass, the state legislative analyst’s office estimates that debt service would peak at 5.9% in fiscal 2010-2011 and decline from there.

A 6% debt service doesn’t trouble bond rating firms.  David Hitchcock, who tracks California’s fiscal health for Standard & Poors, says a 6% debt service level would be ‘moderately high’ in relation to other states, but still well below the levels of some more aggressive borrowers.  New York’s debt service burden is 8.6%, according to S&P; Massachusetts’ is 7.9%. 

So, if the bonds pass, the hit to California’s existing debt might well be negligible. 

But, if we press a little bit, everything depends on the assumptions involved in the above analysis.  Namely, it depends on the assumptions for the state’s tax revenue.  If the economy has problems things would look very different.  State debt service costs would be going up at a time when revenue might be going down.  Given the housing situation and its importance to California’s economy, I consider this a serious and likely consideration.  Were housing to crash in California, hurting the economy and therefore tax revenues, these bonds will get hit. 

And, to be fair, Petruno does make note of this possibility:

That risk could surge if the economy ebbs and tax revenue shrinks, which was the chain of events beginning in 2001. 

If the budget goes back into the red, the infrastructure bond-debt burden suddenly might begin to look much more onerous. 

Another budget crunch could have the same effect as the one in 2003: California bond yields could temporarily soar.  At the peak of yields in 2003 you could buy a 20 year general obligation bond paying 5.5% a year tax free. 

Petruno and the CA municipal bond mutual fund managers he cites in the article aren’t worried.  But I think they’re wrong not to be.  But it does mean that you probably have time to reduce your exposure to California state debt.  Given the potentially increased debt and the California economy’s dependence on housing, I would do so.  As the housing bust and its effect on California’s economy plays out over the next few years, you should have an opportunity to pick up California debt at more attractive prices.