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Downgrade Risk and Yield Opportunties in California

Miriam Sjoblom, CFA

Sjoblom: Well, you mentioned the credit ratings, too, and it seems as if the market was pricing in expectation of downgrades. We did have, sure enough, Fitch come out, followed by Moody's, and downgrade the state. If you're not concerned about default risk, should people be concerned about downgrade risk? I suppose, what impact have the downgrades had on the market?

Costas: Well, clearly the lower-rated you are, the more you're going to pay in terms of interest costs. That's how the market works. That's how it should work. When something is this big and this public, the market is pretty good about anticipating, especially downgrades. I think the market seems to have already gotten there. What the rating agencies do in terms of getting to the BBB level will be just a formality at the time it happens. Once you get there, then the questions will begin to arise, "Well, what about going lower than BBB?" That will depend on what is happening in Sacramento.

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As of this morning, today being July 16, there was an article in The Wall Street Journal that there seems to be--they're pretty close to an agreement. The Wall Street Journal wouldn't put that out if it's not a believable story.

If that were the case, you'll probably start seeing a stop to the downgrade concerns, but if that falls apart, and we're sitting here three weeks later, and we're still at impasse in Sacramento, then you start having that kind of conversation. Then, of course, the interest penalty will be even higher until we actually solve the problem.

I should say that being late on a budget, as I think you alluded to in the beginning, is not a very rare thing for California. Most of the time, we do miss the deadline. So, the fact that we're late with the budget is nothing new. It's the severity of the budget deficit in the middle of the greatest recession that we have seen since the Great Depression.

Sjoblom: Right. Well, one thing I'm wondering too that I get asked about is whether this is contained to impacting the state GO bonds (or the state's debt generally). I know there's lease debt as well to consider. Or, can the state's fiscal troubles have a spillover impact onto other muni issuers in the state? For example, if the state has to make budget cuts, it could end up harming some issuers.

Costas: Yes, you're right. This doesn't just affect the state GOs. By perception alone, it affects a lot of issuers within California, some of which would be unjustly hit with some of the shrapnel. On the negative side, that does hurt some issuers. On the positive side, as buyers and people who are looking to invest in California, it is creating some yield opportunities for us that may not have been there three or four months ago had this not been happening. We of course ask the question of what can be the spillover effects for things like school districts, counties, and so on that depend on some state aid, but from what we have seen so far, while it's not a positive situation, it doesn't seem to be threatening any issuers that we are aware of right now with getting into a default situation either.

So, it's not easy, but we have found so far that the subdivisions of the state: all these, again, counties, school districts, and water departments, sewer departments, electrics, and so on--you can go down the line--seem to have done a much better job of being responsible about looking coldly at the facts and making some very tough decisions at the local level.