Advisor: Muni's no longer seem the deal they once did, but some deserve a look (even in California)

Elizabeth’s note: As an online company with multiple offices, RIABiz hasn’t had too many dealings so far with local and state governments. The one exception is sales tax. Because we collect and pay sales taxes on our reprint orders, we needed to register in a number of different states. The bureaucracy in California was so bad that it took us about six months to fill out the correct paperwork. I complained bitterly to my San Francisco-based partners, contrasting the ill management in California with fiscal affairs in my state of Virginia, which has been called the best-managed state in the country. But in all fairness, it was North Carolina that took the cake. After we registered there, the state sent RIABiz a booklet that said, “Congratulations on being a coal mine in North Carolina!”
California has its problems, for sure. But this analysis by experts at HighMark Capital Management offers some assurance that the state will avoid the worst-case scenario of default on its municipal bonds.

RIAs today are faced with a changed municipal market landscape. Advisors can no longer rely solely on insurers or rating agencies to access creditworthiness. The municipal broker-dealer community has changed. As a result of consolidation among the large firms, regional firms are taking more market share – but that means it’s harder for individual investors to find municipal bonds. See:Schwab gives investors seat at the table for new-issue municipal bonds with J.P. Morgan deal Advisors are now faced with devoting more time and resources to managing municipal assets for their clients, including the complicated task of performing fundamental credit analysis on each potential bond.

Against this backdrop, new questions are arising about the security of municipal bonds as an investment. The recession has dealt a hard blow against municipal budgets. In this Q&A, the tax-exempt fixed income team for San Francisco-based HighMark Capital Management delves into the highest-profile municipal problem, California. This analysis also sheds light on the municipal bond market in general.

Q: California’s budget issues are in the news. Explain the difference between the State’s creditworthiness and its’ most immediate problem of liquidity?

A: While the deficit for the 2010-11 fiscal year is currently estimated to be $19.1 Billion, debt service on the State’s bonded debt will likely continue to be paid in a timely manner. State cash flows are volatile throughout the year, so intra-year liquidity needs are typically met through the issuance of Revenue Anticipation Notes (RAN’s). A budget must be in place before the State can issue the RAN’s. This is the second year of budget stress during this recessionary period and it will again provide a confrontational summer in Sacramento, as legislators grapple with raising revenue and cutting expenditures to create a balanced budget. Both note and bond investors will be paying particular attention to budget solutions for assurances that their notes and bonds will continue to be paid in a timely manner.

Q: What is the latest on the California budget?

A: As of this date, it does not appear that the parties in Sacramento are close to a solution. The State Controller has sent a letter to the legislative leaders stating that if they do not act soon he will have to begin to conserve cash. The Controller noted that the State appears to have sufficient resources to continue operations through August. Inaction by the Legislature will likely lead to the issuance of IOU’s again this summer.

The Governor has proposed the following revised (as of May) budget solutions:
• $12.3B Expenditure reductions (64.6% of shortfall)
• $3.3B Federal funds (17.7% of shortfall)
• $1.2B Alternative funding (6.7% of shortfall)
• $2.1B Fund shifts and other revenue reductions (11% of shortfall)

California’s solution will be a political one. Much of this budget solution is on the back of expenditure cuts (64.6%) which were mostly to social services, so getting legislative approval in this current form may be problematic.

Q: Could the State of California or other states default?

A: Yes, but it is unlikely. A default serves the best interests of no one, the least of which would be the state, which would be penalized when it needed to access credit markets in the future. Additionally, a state default would likely re-price risk for the entire national municipal market, resulting in higher interest rates for all municipal issuers. The last state to default was Arkansas during the Great Depression and eventually, those investors were paid in full. Prior to that period, several states defaulted during and prior to Reconstruction.

Q: Is bankruptcy of a state possible?

A: No. Bankruptcy is a legal status that is not available to states.

Q: What is the priority of payment for California General Obligation (GO’s) Bonds?

A: GO’s are paid out of general fund revenues, which carry the full faith and credit obligation of the State. GO’s are second in line only to Prop 98 funding for K-14 education.

Q: What makes California’s budget issues so challenging?

A: 1. The state has less flexibility than other states in its budgetary process. Structural challenges include the requirement to have a super-majority to pass a budget and earmark funding.
2. The State has a highly progressive tax system which leads to revenue volatility during recessionary times.

Q: Are there any positives to the State of California outlook?

A: 1. The State’s debt burden is modest on a per capita basis and low as a portion of total personal income.
2. The debt is structured in a conservative way, with little variable-rate debt that could be exposed to rising interest rates.
3. The State is important on a national level, as it contributes 13% to US GDP. If it were a country, it would be the tenth largest economy in the world.

Q: Is HighMark buying State of California GO’s for its managed accounts?

A: No, not at the moment. We are looking for greater clarity on forthcoming budget solutions.

Q: How have other bonds issued within the State been affected?

A: Bonds issued within the State have suffered, as bond buyers across the country have avoided California-issued debt, causing yields to rise and prices to fall.

Q: What tax-exempt bonds within the State are you recommending for clients?

A: GO’s (other than those issued by the State) and essential service revenue bonds such as those for water, sewer, and electric system projects, which provide good security, and in the case of essential service revenue bonds, a revenue stream dedicated to paying debt service. Currently these types of bonds are attractively priced compared to similar bonds in other states. Over time, as California’s prospects improve, we believe these bonds will likely out-perform their national counterparts.

Q: What impact will the uncertain future of the municipal bond insurers have on the municipal market?

A: It will require firms to do what HighMark has always done: rely on the credit quality of the underlying security rather than on an insurance wrapper. Additionally, before the crisis, the municipal market had become commoditized, with the majority of bonds rated AAA because of insurance. Now, there are many more opportunities for an active manager to find value because bonds are priced to reflect the creditworthiness of the issuer rather than the creditworthiness of an AAA-rated insurance company.

Q: Where should I be positioned on the yield curve?

A: We are currently positioning our portfolios for a rising rate environment using what we call a “managed ladder”. We define this as a laddered structure of maturities augmented by clustering or over-weighting maturities in areas of the yield curve we believe to be particularly attractive. Generally, we manage our portfolios with an intermediate style because we believe 70% of the available yield in the municipal yield curve can be captured by maintaining an intermediate term structure while lowering volatility.

HighMark will conduct a State of California Town Hall Conference Call on August 11th at 1:15 PDT. To attend, dial into (877) 407-9205. You do not need to register for the call.

HighMark Capital Management, Inc., a SEC registered investment adviser (HighMark), is a wholly owned subsidiary of Union Bank, N.A (Union Bank). HighMark manages institutional separate account portfolios for a wide variety of for-profit and non-profit organizations, public agencies, public and private retirement plans, and personal trusts. It also serves as investment adviser for individuals, mutual funds, common trust funds, and collective investment trusts and also sub-advises certain of Union Bank’s collective funds. Union Bank, a subsidiary of UnionBanCal Corporation, provides certain services to HighMark and is compensated for these services. Investments in the funds and investments recommended by or employing HighMark strategies are not bank deposits, are not FDIC insured or guaranteed by any agency of the U.S. government, and involve risk, including the possible loss of principal. Past performance is not a guarantee of future results.

This discussion is for general information only and is not intended to provide specific advice to any individual. Individual account management and construction will vary depending on each client’s investment needs and objectives. Some information provided herein was obtained from third party sources deemed to be reliable. Specific securities identified and described do not represent all of the securities purchased, sold or recommended for advisory clients, and you should not assume that investments in the securities identified and discussed were or will be profitable.