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California's Credit Rating Poised for a Downgrade

Standard & Poor’s Ratings Services put California on watch for a ratings downgrade today and it’s not hard to see why. The Golden State’s fiscal troubles appear unending. It has a $24 billion budget gap to fill, voters have already rejected raising taxes, and the political will to make hard decisions is apparently AWOL. As it stands, the world’s eighth-largest economy could soon find itself unable to pay its bills. California, which has $59 billion in general obligation (GO) debt outstanding, could find its coffers empty by the end of July.

Scary, right? And while holders of the state’s GO municipal bonds will receive timely payments on the money they’re owed, others may not be so lucky. From the Standard & Poor’s press release:

We believe that without budget revisions, the state may need to defer (or issue registered warrants in lieu of making) cash payments for certain lower-priority obligations (such as vendors, student aid, and tax refunds) in order to preserve cash for required payments for education and debt service.

California’s municipal bond investors must be feeling pretty peachy right about now. Remember, these are the same folks who gobbled up over $13 billion in tax-free, taxable, and Build America bonds issued by the state in 2009 alone. California’s budget shortfall was obvious even then—so obvious, in fact, that BusinessWeek warned of a possible downgrade in our April 13 issue.

I asked Warren Pierson, portfolio manager of the Baird Intermediate Municipal Bond Fund (BMBIX), a source for that story, how he feels about those bonds now and his opinion hasn’t changed. He doesn’t think California will default (though the cost of insuring California’s debt is rising rapidly). But the bonds are still too pricey for his liking. Even after falling 7% in the last month, the bonds are trading near face value and have room to fall further.

States are not permitted to declare bankruptcy, so investors who plan to hold until maturity will likely be fine. And the debate has already begun about how much help California should get. Is it too big to fail? Does helping California mean helping other states as well?

These aren’t academic questions. Says Pierson: “California isn’t the only state with budget problems.”

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