California balancing its budget has broad positive implications for perception of the entire muni market.  Munis have been trending up (tightening) for the last several weeks. Municipal bond fund outflows have recently declined precipitously.  Although there have been over 26 consecutive weeks of outflow for municipal funds, the magnitude has dramatically reduced.  Additionally, a number of fund types – national municipal funds and high yield municipal funds – saw inflows. A California muni bond issuance moratorium put in place by Governor Brown in January as well as a no tax increase budget proposal to close the budget deficit, abolish redevelopment agencies, increase efficiency, reduce operating budgets across the state by 5%, and delay repayment of internal borrowings has substantially compressed (this is positive for prices) California muni bond spreads.

There are more significant implications for investors than just headlines.  Given the scarcity of California paper and the historic performance of its debt during last year’s budget crisis, the prospect of adverse headline risk for California state-level debt is modest.  The larger potential impact is not for California debt as much as it is for the perception of municipal debt to the investor. 

The optics of municipal credit from late 2010 through early 2011 was largely framed by pundits using a common quote of projected cumulative state budget deficits for fiscal year 2012 of more than $110 billion.  California’s budget deficit represents almost one-quarter of that figure.  The redemption wave that swept over municipal mutual funds can only be reversed if investors believe that municipal credit is safe – or at a bare minimum is not in the vortex of a financial catastrophe.  This is best achieved through education, but that is neither a short nor easy process.  Certainly, the growth of participation in the new issue market over the past several weeks is evidence that investors are generally moving along this education continuum.

California’s drive towards a balanced budget has the potential to serve as a catalyst to move investors beyond the perception of systemic risk in municipal credit.  The expenditure reductions achieved in California to date ($14 billion) and Illinois tax increase ($6.5 billion) alone represent more than 18% of the $112 billion figure cited by the Center on Budget and Policy Priorities.  Add in Connecticut closing a $4 billion deficit and New York closing a $10 billion deficit and the percentage of the fiscal 2012 budget deficits that have been closed increases to more than 30%.  The magnitude is important, but so is the way in which the deficits have been closed.  Substantial recurring expenditure cuts and revenue raises have both been made and more are on the way.  It is difficult to get such points across to investors until after the trend is obvious to the general public.  California ultimately balancing its budget may be the final lesson.

Michael Ashley Schulman, CFA
Managing Director
Hollencrest Capital Management