Dec. 10 (Bloomberg) -- Franklin Advisers bet on California municipal bonds in 2009, when the state was so broke it had to use IOUs to pay its bills.
The wager by the arm of Franklin Resources Inc., which oversees $750 billion of assets, has enabled the company’s flagship national tax-exempt fund to beat 89 percent of its peers in the past five years. It returned an annual 6.3 percent on average in the period, data compiled by Bloomberg show.
With the world’s ninth-biggest economy recovering to the strongest since 2008 and voters approving tax increases set to take effect next month, California bonds have outpaced a post-election rally in the $3.7 trillion muni market. The extra yield investors demand from California issuers over AAAs dropped to 0.53 percentage point last month, the lowest in four years.
“California was unfairly penalized in the market,” said Paco Rivera, who helps oversee $85 billion of munis for Franklin, which is based in San Mateo, California. “They were going to raise revenues by raising taxes or cut expenses by cutting services, and that’s exactly what the state is doing.”
Fitch Ratings last week joined Standard & Poor’s in saying the tax plan that Governor Jerry Brown championed may bolster the most-populous state’s credit. Both companies give California the lowest grade among U.S. states, at A-, six levels below AAA. Excluding so-called recalibrations, neither has raised the grade since 2006.
“I hope it means there are upgrades in the future,” California Treasurer Bill Lockyer said in a telephone interview. “Rating agencies typically want to see a multiyear trend and not just a shorter-term one. This is year three of more balanced budgeting and more fiscal discipline.”
The state is poised for a budget surplus by 2015, according to the state Legislative Analyst’s Office, after a decade in which lawmakers faced cumulative deficits of more than $200 billion.
California debt has earned 10.5 percent in 2012, S&P data show. It’s poised to beat the broader muni market for the third straight year.
Helping fuel the gains, Brown has curbed debt sales since he took office last year. He trimmed new general-obligation bonds in the last two years to $7.5 billion, from $30.8 billion the previous two.
Voters in the state, which hasn’t had a budget surplus in a dozen years, approved higher sales and income taxes Nov. 6, the first statewide increase since 2004. Brown, a 74-year-old Democrat, sought higher levies to help erase a $16 billion deficit in the year that began July 1.
“There is a strong likelihood that the state will have operating surpluses” by 2015 if the economy grows and lawmakers keep spending under control, Mac Taylor, the state’s independent fiscal analyst, said in a November report.
Franklin began adding the state’s general obligations in March 2009 to the Franklin Federal Tax-Free Income Fund and the High Yield Tax-Free Income Fund, Rivera said. By the end of 2010 it was the largest holding in both. Two years earlier it was second-biggest in the national fund and 44th in the high-yield portfolio.
Back then, “there were enough bonds to go around, because no one else had money or conviction on the credit,” Rivera said.
California in July 2009 began issuing IOUs to pay some creditors, a step taken only once before since the Great Depression. The same month, Fitch cut its rating to BBB, the second-lowest investment grade and matching its lowest level ever.
The yield penalty on California issuers reached almost three times the current level in 2009, Bloomberg indexes show.
Individual buyers seeking to avoid taxes have helped drive gains in the past month. They added about $221 million to California muni funds in the four weeks through Dec. 5, the most since April, Lipper US Fund Flows data show.
“The increase in tax rates makes the tax exemption an even better value” for California investors, said Dan Solender, who manages $19 billion of munis at Lord Abbett & Co. in Jersey City, New Jersey.
The state’s improving fiscal situation still faces risks, with more than $600 billion of federal tax increases and spending cuts set to take effect next month unless Congress acts.
Should those levies and reductions cause the U.S. economy to fall back into recession, it would cut about $11 billion from California tax collections over the next year and a half, Taylor’s office estimates.
For now, California’s economy is near its strongest since 2008, according to a Comerica Bank index measuring activity including nonfarm payrolls and building permits.
Yields on 20-year general obligations of issuers nationwide fell last week to 3.27 percent, the lowest since August 1965, according to a Bond Buyer index.
Following is a pending sale:
CALIFORNIA POLLUTION CONTROL FINANCING AUTHORITY plans to sell about $781 million in revenue bonds as soon as this week, according to data compiled by Bloomberg. Part of the proceeds will be used to construct a desalination plant and a pipeline in San Diego County. (Added Dec. 10)
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