California's Big, Fat High-Yield Debt

By RANDALL W. FORSYTH | MORE ARTICLES BY AUTHOR

California, Greece: see protests, hustle bonds.

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AS DEMONSTRATORS PROTESTED THURSDAY AGAINST measures to pare Greece's budget deficit, the Hellenic Republic found ready buyers for a big bond offering.

Meanwhile, in California, college students demonstrated against cutbacks to the Golden State's higher-education institutions ahead of next week's offering of $2 billion general obligation, or GO, bonds. Same stuff, different place.

Greece's auction of 10-year bonds drew 14 billion euros in bids for the €5 billion offered, albeit at a yield of 6.35%, well over the 6.08% on the comparable outstanding issue. That brought the spread over the German bund to about 300 basis points, or three percentage points, above the euro-zone benchmark bond. (One euro fetches about $1.36.)

Last week's sale merely put a dent in the €20 billion the Greek government must raise in the next three months. Some German officials helpfully suggested that Greece sell off some islands. Not jewels like Santorini -- just some uninhabited islands, presumably fit for your basic plutocrat.

Instead, the Greek government announced €4.8 billion in austerity measures, which provoked strikes in hospitals and schools and shut down public transportation in Athens Friday. Still, George Papandreou, the Greek prime minister, came away from a meeting in Berlin with Angela Merkel, the German chancellor, with a pledge to do "everything in order to stabilize the euro" -- but no financial support from the European Union's biggest economy.

Nevertheless, global investors apparently have concluded that the yield on Greek government debt -- roughly twice that of German bunds (government bond) -- compensates for the risk. Indeed, foreign investors took 77% of the Greek offering, with the biggest demand coming from the U.K. and Germany, Reuters reports.

Back in the U.S., California may have to pay nearly as much as Greece -- upwards of 6% on a 30-year maturity. But there's a significant difference. California's GOs' interest will be exempt from federal taxes, and for investors in the state, exempt from California's stiff income levy. For affluent Californians facing a 40% combined federal and state tax rate, a 6% yield on a double-exempt bond would be equivalent to a 10% return on a taxable bond.

Ten percent would be a yield appropriate for a corporate junk bond. And in the view of many, California qualifies as a junk credit. The ratings agencies, for what it's worth, still put the state in the investment-grade range: Baa1 by Moody's Investors Service, single-A-minus by Standard & Poor's, and triple-B by Fitch Ratings.

Whatever some might say, California isn't a junk credit. It is, after all, the world's eighth-largest economy, dwarfing many other sovereign debtors, including Greece, which is small even within the European Union.

Moreover, for California to default on interest and principal payments on its GO debt is all but unthinkable. As often trumpeted, debt-service payments on California take precedence over everything other than payments for schools under the state's constitution. Even so, "California is role model for how not to manage a large state," says Howard J. Cure, director of municipal research at Evercore Wealth Management, which manages $1.6 billion for high net-worth individuals.

Jobs Report Jolts Treasuries: News of a smaller-than-expected drop in payrolls last month sent yields sharply higher for the week. The market also is braced for a heavy slate of Treasury note and bond auctions this week totaling some $74 billion.

The state's problems are traceable to its dependence on volatile high-income and capital-gains taxes, which drive wealthy taxpayers out of state; lack of rainy-day reserves; an unaffordable, generous safety net for citizens; the need for a two-thirds majority in the legislature to raise taxes; and the initiatives process that sets constitutional requirements without providing funding. As a result, Cure thinks further downgrades are likely in California GOs, even though the state's economy is showing signs of recovery.

Ken Woods, head of Asset Preservation Advisors in Atlanta, thinks the state's bonds are "money-good." While they trade about 150 basis points over the triple-A municipal yield curve, which equates to about 4.50% in 10 years and just under 6% in 30 years, he thinks there's better value in the bonds at a spread closer to 200 bps. At their widest last year, 10-year California GOs only got to about 170 basis points over the triple-A muni scale, says Evercore.

For investors looking for California credits, Cure prefers essential-service enterprises, such as water, sewer and public-power bonds, which aren't dependent on Sacramento; selected sales-tax bonds; bonds from the world-class University of California system (but avoid the California State University and school-district issues); and stronger cities and counties, although the state is likely to shift expenses to them; and community colleges.

IN THE TREASURY MARKET, prices fell and yields rose sharply Friday, following news of a smaller-than-expected 36,000 drop in payrolls in February and ahead of this week's slate of $74 billion in note and bond auctions. For the week, the two-year note's yield rose nine basis points, to 0.90%; the benchmark 10-year-note yield was up eight basis points, to 3.69%; and the 30-year bond yield increased nine basis points, to 4.64%.