Funny Business

Published: Tuesday, 30 Jun 2009 | 2:27 PM ET

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The more turmoil in California, the more attractive its bonds? "Yes," says Jon Schotz, Chief Investment Officer at Saybrook Capital in Santa Monica.

He and others are hoping to scoop up California's general obligation bonds in the coming weeks as the budget impasse hits DEFCON Delta. "California bonds have never been this cheap," he says. Yields are around 6.2%, which equates to 9.5% or even 10% of a taxable bond. But Schotz is actually holding off buying for a week or two, expecting yields to go higher. Seven percent? Possible, though "that would be unprecedented."

He's buying even as Martin Weiss of Weiss Research tells Fortune, "Sell all California paper now!" Our own Jim Cramer says he's concerned about California munis, and he's never concerned about munis.

But Schotz and others believe the California constitution guarantees very little risk. By law, general obligation bondholders are second only to education in getting paid by the state, and California still has plenty of revenue coming in to cover those costs. "The entire prison system, all local aid, the medical system, the highway system, most things that the state pays for will have to not get funded before the bondholders don't get paid," says Matt Fabian, Managing Director of Municipal Market Advisors. He put a "buy" rating on California bonds this week. But GM

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[GMGMQ  Loading...      ()   ] bondholders learned one's place in the food chain isn't always secure. However, Schotz points out that it would take a constitutional convention to force bondholders to the back of the line, and California, unlike GM, cannot seek protection in bankruptcy. Still, these are unprecedented times and one never knows what political leaders might try...

Schotz and Fabian are only interested in purchasing the state's general obligation bonds, not any other California debt, nor any debt from a particular city or county. For one thing, the state can force local governments to lend it money in time of need. "So a city that could be doing very well, all of a sudden could lose a bunch of sources of revenue," says Schotz, "and you as a bondholder could do nothing about it."

There isn't much activity of California munis on the secondary market, which surprises Schotz, who figures too many potential sellers are "paralyzed".

At the moment, there isn't much in the way of new issuances, given the budget crisis. But Matt Fabian says whenever a budget is passed, the state will issue short term cash bonds, called revenue anticipation notes (not warrants, which have a soft maturity that can be changed by the state).

Those notes should mature in a year, he says, with yields of around 4% or 5%. "For one-year paper, to get that kind of yield, I think it's a pretty good opportunity, particularly if you are concerned about California's longer term prospects."

As for other states, Schotz is only mildly interested in a few, and one he wouldn't touch. "Florida I can't stand as far as a bond," he says. "There's no good source of revenue because there's no state income tax, and the property taxes get reassessed every two years, and property values have fallen off a cliff in Florida. So how are they going to balance their budget? I don't see a clear answer yet, and until there's some notion of a clear answer, I wouldn't put my toe in the water."

I've included more of the interviews I did with both men here on this post.

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