Today California is facing a political and financial crisis of epic proportions. Rumors of default are gaining momentum and the continued ineffectiveness of the elected class in Sacramento has done nothing to allay the concerns of investors.
But is there a real risk of financial default? Does this represent an investment opportunity for the astute investor? The answer to the first question is no and the answer to the second is yes.
The challenge for investors will be to recognize that the assumption of a “buy and hold” municipal portfolio may have to be tempered against one of the most politically-charged environments wherein tax and policy changes could immediately impact one’s net worth.
This year is a crucial election year in California with two key races: one for Governor and one for Senator. In addition, Sacramento will be engaged in the “budget process”, which, if it is even remotely like prior sessions, will not accomplish anything until later in 2010. So, volatility will be the watchword for investors in California municipals.
At SoHo, we believe that there will be two types of default: financial and emotional. There are bonds in California that will exhibit the challenge of debt service and wherein bankruptcy will be a real option.
We aren’t recommending that anyone consider these as investments. However, plain vanilla California General Obligation bonds, pre-refunded bonds, and essential services bonds will represent an investment opportunity.
Regrettably, we feel that the unsophisticated individual investor will be susceptible to the headline risk this year and sell their bonds at a discount. Today, those bonds yield approximately 10% pre-tax, and may see much higher levels as a consequence.
The prudent investor can simply wait until the fall, as the political rhetoric reaches a crescendo, and purchase these bonds at a discount.
Is there a risk of default? There are two crucial answers. First, the state’s debt service represents $6 billion of approximately $82 billion in revenue. So California has ample coverage to pay.
Second, look at Article 16 of the State’s Constitution for the words “continuous appropriation”. As dysfunctional as Sacramento is, they cannot change the state’s Constitution and the debt service will be paid on-time.
Lastly, we have a potential “bid” developing from the Federal Government. If the discussion regarding changing the tax treatment of tax-exempt securities gains momentum, you may well see a scarcity of supply of these tax exempt municipal securities. This will have the welcome consequence for our investor of higher prices for the municipal bonds he bought so cheaply.
The old adage of buying low and selling high may quickly present itself to the intelligent investor who reads the fine print and stays out of politics.
Frank Troise is Senior Portfolio Manager at SoHo Asset Management LLC.