Monday, October 15, 2012

California munis return from the dead as investors bid up bonds, but risks remain

In another sign of strong demand for fixed income product (basically anything with extra yield) the muni market has been quite strong. In particular the tightening in the California's bonds has been extraordinary. California 10y general obligation (GO) paper has been trading at some 50bp spread to the national average (chart below) as the issuance of new bonds has slowed.

Source: JPMorgan (click to enlarge)

The rating agencies seem to have gotten fairly comfortable with what looked like a bankruptcy in the making just three years ago.
Fitch (via Reuters): - Fitch affirms the 'A-' rating on approximately $72.6 billion in outstanding GO bonds of the state. The Rating Outlook is Stable. SECURITY General obligations, for which the state pledges its full faith and credit, subject to the prior application of moneys to the support of public education; funds for education represent approximately half of state spending. KEY RATING DRIVERS WEALTHY, DIVERSE ECONOMY: The economy is wealthy and unmatched among U.S. states in its diversity and breadth. Growth has resumed after severe, widespread recessionary conditions.
The rating agencies are hanging their hat on the size and diversity of California's economy. To put things in perspective, the chart below compares California's output to the largest economies in the world. California's "GDP" is larger than that of India, Canada, Russia, Spain, Australia, etc.

Source: JPMorgan (GSP = Gross State Product)

Nevertheless risks in California GOs remain, and investors should exercise caution - particularly at such tight spreads.
Fitch : - 
HISTORY OF BUDGET AND CASH STRESS: State finances are subject to periodic, severe budget and cash flow crises due to structural imbalances, revenue cyclicality and institutional inflexibility.

VOLATILE REVENUES: Revenues are volatile, notably the component tied to personal income. Modest revenue growth has resumed since the downturn although the course of future collections is uncertain.




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