California’s deficit gives investment manager pause

Transcription:

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 Mike Scarchilli (00:04):

Hi everyone and welcome to The Bond Buyer Podcast, your essential resource for insights into everything municipal finance. I’m Mike Scarchilli, Editor-in-Chief of The Bond Buyer, and today we’re bringing you an in-depth conversation focused on California’s municipal bond market. In this episode, our senior reporter in the Far west region, Keeley Webster, sits down with Craig Brothers, a partner at Los Angeles based Bel Air Investment Advisors with $4.3 billion in assets under management. Bel Air’s portfolio is heavily weighted toward California debt, but Craig shares why they’re steering clear of certain state bonds at this time. They discuss the state’s budget volatility. Its reliance on personal income taxes from the top 1% and how Proposition 13 impacts the state’s revenue. Craig also explains why Bel-Air prefers revenue bonds over California general obligation bonds or public works bonds given the state’s current fiscal landscape. It’s a fascinating discussion for anyone navigating the complexities of California’s municipal bond market, especially as economic uncertainties loom and with The Bond Buyer’s flagship California Public Finance Conference on the horizon. So without further ado, let’s jump into this timely and engaging conversation.

 Keeley Webster (01:22):

Hi, I am Keeley Webster, a senior reporter with The Bond Buyer. Today I have here with me, Craig Brothers, a partner with Los Angeles based Belaire Investment Advisors. Belaire has $4.3 billion in assets under management and according to brothers, the lion’s share of that is California dead. Why is Bel Air so heavily weighted toward California paper?

Craig Brothers (01:43):

Well, if you look at the breakdown of our client base, the firm was started in California and we have our biggest presence in California, probably in our fixed income book. Roughly two thirds of the assets are for California investors, the other one third or for clients that we’ve developed outside the state. And our clients are in the 1% that are paying the highest income tax in California 13.3%. So we are really only giving them California paper because to go outside the state and buy them a bond and then pay that tax, it almost always comes out where they’re losing. So we’re sort of trapped to buy only California paper because of the high tax hurdle that California has for its highest bracket.

 Keeley Webster (02:42):

So Craig, we were speaking last week about why Bel Air is in currently interested in California general obligation bonds or at state public works revenue bonds because of the state’s current budget situation. Could you explain for our listeners your thinking behind that?

Craig Brothers (02:58):

I would say it’s not that we fear that California will not be able to pay, they can’t declare chapter nine bankruptcy. It’s AA rated credit. We view it as a good credit, but we’ve also view the states budget situation as something that is super predicated on what’s going on with the stock market. If you look at the personal income tax is the number one generator of revenue for the state, and of that 50% of that personal income tax basically comes from the top bracket, the top 1%. And so there’s a cyclical nature to the tax collection from this one group because it’s not just income tax that they’re paying, it’s capital gains. And so if they have a bad year and the stock market, the tax receipts drop way, way off. And so it’s this sort of roller coaster of the state having good years when the stock market is booming and having poor years when the stock market is weak, that we really don’t want to be subjected to that.

(04:08):

Perfect example is after the market downturn in 22, the 2223 tax revenues dropped by 25%. So that’s a perfect example showing you that that top bracket really suffered in that year that they weren’t going public with new stock issues, they weren’t selling company stock at a profit and the receipts dropped off. And so this is cyclical nature that the state has. The other thing to think about is Prop 13, which is the only benefit of California having a tax that’s less than the rest of the country is capped. And so because that’s capped and that’s a much more stable revenue source where real estate essentially is steady to up, really doesn’t have the ups and downs like the equity market, you could really build a budget off of that. But because that is a constant and really doesn’t go up by that much and can really only go up by 2% per year at the most, it’s whichever is lower CPI or 2% that that’s a steady source of revenue, but it’s not going to have the big impact that the personal income tax. So they can count on that, but they can’t count on the revenue that comes in from personal income tax because of that cyclical nature what they tied into the equity market.

 Keeley Webster (05:45):

So the Prop 13 money covers property taxes and local government though. So are you saying that you’re more comfortable in investing locally rather than at the state or how does the whole prop 13 issue fit into your investment strategy?

Craig Brothers (06:04):

Well, Prop 13 is something that it affects the whole state, but the impact is big on both the state and local levels. If the state was able to have a higher source of revenue from property taxes, that would sort of offset the reliance on personal income taxes. Now if you go down to the local level, you have to look at that and realize that those municipalities are also somewhat capped into what they can get because of that Prop 13, we’re worried somewhat that the pension liability is growing at the local level and that the state might eventually have to come in to help that. That’s another thing with the state budget. You have a growing amount of obligation with the pension liabilities. And so if you think of the state as needing to set aside for a growing pension liability and that now that their borrowing cost has gone up, it becomes a situation where we think in the next recession the state is likely to have another budget shortfall.

(07:32):

The audited financials have not been ready after nine months, and so they’ve had five years straight where they haven’t complied with that. And so if you think of this as if they’re notoriously late and they have back to back years, that hasn’t happened. It did in the financial crisis. But if you have back to back years of budget shortfalls and the state tries to solve this by sort of rearranging the deck chairs, they’re either extending their payments, they’re not to trying to find a way to balance it, but they’re not doing real cuts. They’re doing it with borrowing, taking money down from the reserve fund. I think Gov. Newsom’s latest proposal is to take half of the reserve fund to balance, and then the Democratic legislature talked about 2 billion in cuts, but the shortfall is not going to be closed by those two measures. And so what they ultimately end up doing is giving less money down to the municipalities, the school districts, and sort of papering over their issues until they have a better year. What we worry about is where they’re already in a shortfall and then that follows up with a second year of a down year in revenue collection from a negative stock market. So right now they’re drawing on those reserves. The reserves are likely to be gone by the fiscal 25, 26. It’s difficult to replenish those unless it’s in a boom year. So we worry that they’re going to have no reserves and potentially the revenues challenged.

 Keeley Webster (09:23):

Has your thinking changed around that over the past couple of years? I mean, I don’t feel like when we had spoken before in previous years that you’d mentioned that you weren’t buying California geos. So what time did you start to become uncomfortable with buying the public works bonds and the geos?

Craig Brothers (09:51):

Well, in the financial crisis, which is our main way of looking at when things really get bad, we were buyers of the state’s paper because the fear and volatility was at its maximum. And when we could get that credit yield spreads that approached 75 basis points over the high grade scale, we were happy to do it because we feel like the states, the rollercoaster that I’ve been describing, if we’re buying it when people are the most worried, we’re happy to buy it. We’ve been able to get by for quite a few years, but we really have not been big buyers of this probably for over 10 years we’ve been able to find other areas that we like better. I mean, our primary focus is in revenue bonds and revenue bonds basically make up half of our total California book. And we’re way more comfortable owning revenue bonds because we feel like the revenue bonds don’t have any of the cyclicality that the state has.

(11:00):

We’re talking about essential service credits, water power, and these bonds all have net revenue pledges that give the bonds a rate covenant that’s anywhere from 1.1 to 1.25 times. There’s no pension liabilities to worry about, and they’re just not cyclical tied into what’s happening with the stock market or the economy. They have the ability to adopt service for somebody that’s not paying. So we feel that these are the credits that we really want to own. If we have to pay up a little bit for those, we’re fine doing it because we don’t think that there’s ever going to be a downturn that will harm the rating or the credit worthiness of these credits as opposed to the state, if the state runs into a second back to back years or they can’t get this shortfall balance the way they’d want to and they’re sort of kicking the can down the road at some point.

(12:00):

This is a very heavily owned credit and people might mutual funds, ETFs and whatnot are very exposed to it. And so as it starts to widen, we’d be happy to be a buyer, but we don’t want to buy it basically flat to the high grade scale when we’ve seen issues in the past where it could widen to 50 or 75 basis points. And meanwhile, the credits that we do favor those are not going to be subject to those kind of swings and value. And so that’s really our view is to emphasize this type of paper, have this be kind of the bedrock of our portfolios, and then look to add on credit dislocations. I mean, if you think about muni bonds in general, they’re just such a safe asset class that it’s not a question of them paying. Essentially our whole book is a rated or better, and an A rated muni has a lower default rate than AAA rated corporate. So we’re not sort of dancing around credits we think that won’t pay. We just like to try and add alpha by buying credits when people are more fearful of ’em and have our analysts do all the work and figure out where our downside is, and then the portfolio managers try and figure out where fair value is based on historical trends with spread widening and whatnot.

 Keeley Webster (13:29):

Okay, thank you. Now we’re going to go to a commercial break and we’re back. So the state is currently rated AA two by Moody’s AA minus by s and p and AA by Fitch ratings. Moody’s revised its outlook on the state to negative from stable in May, 2023, setting the state’s revenue uncertainty and s and p revised its outlook to stable from positive in December, Fitch assign a stable outlook. Why do you think the state continues to do so well when it prices debt, including geos and state public works given its current fiscal situation and the recent changes in outlook from s and p and Moody’s?

Craig Brothers (14:13):

Well, I think Moody’s is on the right track, having the outlook be negative. I mean, we agree with that. I mean, they’ve cited in their reports that there’s a weak in uncertain revenue environment, and that’s definitely true of that dependency on the top 1% and the volatility we’ve seen in the past with that. So I a hundred percent agree with Moody’s on that. I mean, there are some challenges also down the road, like I mentioned earlier, that they might end up having to help school district pension contributions because those have been lagging. And ultimately the state really does have to help the local school district, so they might end up having to supplement that if that really gets out of hand. They’ve got their own pension issues also. But the reason why the state credit does so well is because you look at the positives, you look at how big the state is, how the wealth that’s generated by Silicon Valley, basically that area is a huge boom in terms of the businesses that have been created.

(15:24):

If you look at all the big tech companies, they’re essentially based there. I think it definitely punches above its weight. I think the San Francisco Bay area accounts for like 20% of the population, but 40% of the personal income tax collected. So it’s easy to find positives with the state. We’re not saying that the state doesn’t have numerous positives going for it, but what we view is, like I said earlier, is that cyclicality of the state’s budget and revenue, and they’re also now taking on new programs if they’re going to be trying to help migrants, and that’s been very expensive. These are things that the state’s taking on additional burdens, but you also have an incentive for people to move outside the state to try and lower their tax burden. We’ve seen at Bel Air clients that have moved from California either to Texas or to Arizona, and the state really can’t afford to have a big migration outside to the low tax states. If you’re dependent on this one small group and incrementally that’s shrinking, that’s not really great for the revenue that you would expect to see. The state is also suffering from the highest unemployment rate in the country right now. So if you have,

 Keeley Webster (16:55):

So Craig, can I take you, let’s get back to bond pricing on that because I had a question related to what you were saying at the beginning. So you’ve said there were a lot of positives, there are some negatives, and is what I’m wondering is do you feel given their AA ratings that they’re pricing too rich right now for where they’re actually at legitimately? Do you think the ratings are on the mark?

Craig Brothers (17:28):

We think that the rating is maybe a notch generous, not going down to single A, but the Moody’s rating could definitely come down a notch. We also view that it’s trading like aa, but we think that the underlying issues with the state are there and that we’ve seen too many times in the muni market when credit fears come in in a year where you maybe have a recession or a soft patch that these are, our clients are a perfect example. This is their safe money. They don’t want to read in the paper about the negatives about any particular credit that they have. So for us to de-emphasize the state and look to buy it when it’s trading wider is a much better way for us to perform for our clients because we’re in credits that won’t have these issues that are not going to change.

(18:36):

Their rating will not fall in a recession. Revenues won’t fall in a recession. And so if we can get by with owning what we view as the most solid structures and owning essential service credits, we’d rather do that than own the state’s paper. Now, if we were in a giant mutual fund, we probably wouldn’t have the luxury of not owning the state because it comes to market. It’s a massive issuer, and to not buy that, it wouldn’t work. But our size, roughly 4 billion, allows us to not own the state and still find all the credits that we like. And at some point, I think we will own the state credit. Again, it’s just not for us right now because it is trading at a level that we think is rich. If the cyclical nature of the personal income tax comes back to bite the state in the next couple years.

 Keeley Webster (19:39):

Okay. So how much do the reports from the rating agencies and particularly their outlooks affect your view on the state’s credits?

Craig Brothers (19:49):

Well, we have our internal analysis, which sometimes differs from what the rating agencies say. We try to be out in front because the rating agencies are sometimes slow to move on some of this. Also, for a high profile credit, like the state, it’s not easy for them to do a downgrade similar to the US Treasury paper. Things really have to get bad sometimes before you’ll actually see that expressed in a lower rating. So we have our own sort of internal analysis, and like I said before, we’re very comfortable with the types of credits that we’re emphasizing, and it really hasn’t hurt us to not own the state paper. Our book is predominantly aa, so we’re finding great AA rated credits. They just don’t have the same characteristics that State Geo and Cal Public Works do.

 Keeley Webster (20:52):

Craig, thanks for joining us here today. I feel like this was a really robust discussion on investors’ perspective on the state’s credits.

 Mike Scarchilli (21:01):

My pleasure. Thank you. We hope you enjoyed this episode of the Bomb Buyer Podcast. A big thank you to Craig Brothers of Bel Air Investment Advisors for sharing his insights into the challenges and opportunities in the California municipal bond market and to our own Keely Webster for hosting such an informative conversation. Here are a few key takeaways from today’s episode. One, while California’s GL bonds remain highly rated, Craig noted that Bel-Air Investment Advisors is avoiding them. For now, this is due to the state’s reliance on personal income taxes from the top 1%, which makes its revenue highly susceptible to market volatility. In particular, the state’s fiscal health is closely tied to stock market performance, and when the market experiences downturns, tax receipts drop dramatically making the state’s budget unpredictable. Two. Proposition 13, which limits property tax increases was discussed as a double-edged sword. While it provides stability and property tax revenue, it restricts the state’s ability to adjust its budget to meet growing financial obligations such as pension liabilities.

(22:09):

This reliance on a stable but capped revenue stream combined with the volatility of income taxes, puts additional pressure on California’s finances, especially during periods of economic uncertainty. And three, Bel Air prefers revenue bonds, particularly those tied to essential services like water, sewer, and power. Over California’s Geo and public works bonds. These revenue bonds are less vulnerable to the state’s fiscal challenges because they are backed by consistent revenue streams from essential services, and they are not burdened by pension liabilities. As Craig noted, in times of economic stress, these bonds offer more stability and are less likely to be impacted by budget shortfalls or tax revenue fluctuations. Thanks again for listening to The Bond Buyer Podcast. This episode was produced by the Bomb buyer. If you liked what you heard, please hit subscribe on your favorite podcast platform and rate us. Review us and subscribe to our content at www.bondbuyer.com/subscribe. Until next time, I’m Mike Scarchilli signing off.