CALIFORNIA'S COMEBACK
For the second time in less than a week, the state of California
received a credit rating upgrade, continuing a three-year comeback
for the state and vindication for investors who refused to dump
their bonds despite a relentless parade of doomsayers who predicted
imminent disaster for the state.
In raising California's general obligation bond rating to A1 from
A2, with a "stable outlook," Moody's said its upgrade
reflected "the state's strong economic and tax revenue trends,
better than expected financial performance in fiscal 2006, and a
moderately improved financial outlook for 2007 and beyond."
The move by Moody's comes on the heels of a Standard & Poor's
upgrade of California's debt to A+ from A.
Brighter picture
Though California still faces economic challenges, the upgrades
are an unmistakable sign that its financial picture is brightening.
The state has revised its revenue projections to reflect a $7.5
billion increase for this fiscal year as well as 2007. Gov. Arnold
Schwarzenegger's fiscal 2006 budget originally anticipated a fiscal
2008 deficit of $8 billion, while the revised projection is now
$3.5 billion.
The recent action by Moody's affects about $38.3 billion in outstanding
G.O. debt as well as $3.2 billion in general-fund supported tobacco
settlement bonds, which were raised from A3 to A2.
Now vs. then
The current outlook for the state's credit quality is in marked
contrast to July 2003, when Newsweek ran the cover story, "California
in Crisis." At the time, S&P downgraded the state's bonds
to BBB from A, prices declined substantially and many financial
advisors encouraged investors to dump their California bond holdings.
We had a different take. We suggested that despite California's
short-term challenges, lower prices and higher yields on California
General Obligation bonds represented a significant buying opportunity
("Putting
California in its Place"). Investors who hung in have obviously
reaped the benefits.
An old song
But this isn't the only time when investors have profited from
ignoring the financial media. Recently, these so-called experts
besmirched bonds associated with Tobacco Securitization, ACA, General
Motors and numerous others. What these analyses lacked, however,
was a sober, long-term look at the fundamentals underlying the securities.
They demonstrate narrow thinking indicative of a trading - not investing
- mentality.
As California rebounds, keep in mind that its general obligation
bonds are secured by the state's "full faith and credit."
That pledge is supported by California's "ad valorem"
taxing power. Ad valorem taxes are based on the assessed value of
real property - and California boasts some of the most valuable
real estate in the country.
Interesting footnote
In a footnote to his revised budget, Gov. Schwarzenegger disclosed
California's intention to refinance $3 billion of its unenhanced
tobacco securitization bonds. The state expects to generate $900
million to be used to help increase funding for public education.
The actual form of the refinancing has yet to be determined. Although
it is likely to be a conventional refunding, the state may opt to
enhance the new deal with an appropriation pledge. The Bond Buyer
reports that various underwriters have submitted proposals designed
to generate between $400 million and $1.4 billion.
Looking at the broader picture, this action continues a trend of
states seeking to refinance all or a portion of debt secured by
payments from the Master Settlement Agreement reached between states
and tobacco makers, and it's good news for bondholders.
For example, in the case of Iowa's refinanced tobacco bonds, investors
benefited when their Baa-rated 5.60% bonds due in 2035 became AAA
rated bonds, secured by treasury bonds, with a final maturity date
of 2011. This upgrade in quality and shortening of maturity of the
original bonds caused them to trade at a considerable premium. As
the price jumped, clients were able to sell the bonds and purchase
higher coupon tobacco bonds from other states and increase their
annual tax-free income with no additional cost.
When evaluating market news, it pays to be discerning and to understand
the perspective of the source. For example, three years ago, would
Newsweek have sold as many magazines had they printed a front-page
story that was less sensational? We doubt it.
Investing in tax-free bonds is a long-term endeavor. Unfortunately,
it's too often subject to short-term analyses, which, if heeded,
poses significant risks to investors.
06/01/06
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