WHY ADDED DEBT BONDS ARE NOT A GOOD THING

The Bond Advisor (A newsletter for municipal investor tells investors to sleep tight at night, whatever California’s budget woes, schools and debt must be paid first and second: why? Because the state constitution guarantees it.
In last month’s edition, and in several issues last year, the Bond Advisor explained why investors are making a serious mistake if they let catchy and/or scary headlines deceive them about the true status of protection afforded the State of California’s general obligation bonds. Rather than revisit this issue every month in 2010, we are going to let someone else do the talking in this edition and then drop the topic and move on to other things. This “someone else” is worth listening to because it happens to be California Controller John Chiang, and the controller knows better than anyone how the state’s “priority” allocations of available money get made.
Chiang’s comments are particularly timely to review in this edition because California will be selling $2 billion of tax-exempt general obligation bonds on March 11, with a two-day “retail” order period March 9 and 10. As we noted last month, income-oriented investors would be foolish to ignore the yield premium offered on California’s bonds in light of the actual default risk. Yes, we know the state’s credit rating is crummy, but if your goal is to generate as much tax-free income as possible it is difficult to ignore California G.O. bonds. If you can’t stomach buying a lower-rated credit, or aren’t allowed to for fiduciary reasons, there are plenty of muni bond alternatives. Go for those instead.
Let us set the stage before we get to some fascinating observations made recently by Mr. Chiang. These observations were especially fascinating to us because the “mainstream” press ignored them, even though they are the strongest comments yet regarding the treatment of state bond payments during rough times. Over the next few months, just as you saw in 2009, there might be another spate of headlines talking about the state “running out of cash,” going “broke,” etc. As we explained many times last year, California wasn’t running out of cash or for that matter even “short” on cash. The state’s problem, year in and year out, is that it refuses to make the tough decisions that will align spending with actual revenue. No matter where you want to place the blame—federal mandates, overly-generous benefits for public unions, a revenue system too dependent on volatile income tax collections—many state leaders still want the budget to be all things to all people, regardless of the actual revenue coming in the door.
But our main concern, this year as last year, is to explain very clearly that the state is not “running out of cash” or “short of cash” when it comes to the funds available for debt service. The constitutionally-mandated financial cushion that carves out top priorities for education and debt service lets investors sleep at night, even if the “headline risk” would suggest otherwise. Understanding this “cushion” is especially important at a time when the state’s credit ratings are at triple-B levels. Some “conservative” investors, if they go by credit ratings alone, will avoid purchasing California’s bonds. That decision carries with it a major trade-off for an income-oriented investor. You are leaving money on the table because the state’s G.O. bonds are paying a hefty premium over what you will receive on higher-rated municipal debt.
Okay. Enough on that. We have made that point ad nauseam in recent months.