California funds offer opportunity amid risk

The state is projected to have a $38 billion deficit this year.
NEW YORK (AP) -- California municipal bonds and bond funds have taken a hit in recent months amid the state's budget woes and an unprecedented effort to recall the governor.
But though the investments remain risky, some say their beaten-down prices could present buying opportunities.
The state's bond prices have fallen, and yields have risen, particularly after Standard & amp; Poor's last month cut the credit rating of California general-obligation bonds by three notches to triple-B, just above junk bond status. S & amp;P cited the political turmoil.
Though prices edged up after Democratic Gov. Gray Davis signed into law this month a $99 billion budget, analysts say the financial situation remains precarious since the budget relies heavily on borrowing to fill a projected $38 billion deficit this year. The state also anticipates an $8 billion gap next year.
Analysts say the budgetary uncertainty could create potential bargains for investors as Californians decide Oct. 7 whether to recall Davis and install a new governor from a list of more than 100 candidates, including actor Arnold Schwarzenegger and Lt. Gov. Cruz Bustamante.
Federal tax break
In particular, high-income investors in search of a higher yield without the high default risk of junk bonds can benefit. That's because the municipal bonds are exempt from federal taxes, and for California residents, state taxes as well.
"Are prices looking good? Yes. The bottom line is this could be an opportunity for investors," said Lynn Russell, a mutual fund analyst at Morningstar Inc.
For example, 20-year California general-obligation bonds currently yield about 5.44 percent, compared to 4.94 percent for a high-quality triple-A municipal bond, according to Thomson Financial.
For an investor in the highest 35 percent federal tax bracket, the California yield is equivalent to a taxable yield of 9.23 percent.
"There are two things to consider: The California triple-B rating is the lowest of the 50 states rated by S & amp;P at the current time," said Gary Arne, managing director of S & amp;P's Investment Services. On the other hand, long-term experiences with California and other large states indicate they really don't default."
"If it's trading cheap, and people don't see the default risk increasing, some might view California bonds as underpriced," he said.
Still, analysts say that doesn't mean investors should necessarily jump right away into the bonds. They said the state's political climate remains very uncertain, with bond prices still having room to fall depending on the outcome of the recall vote.
Indeed, many municipal fund managers say they are refraining from significantly increasing their exposure to the bonds.
Of concern
They noted the two-thirds legislative requirement in California -- rather than a simple majority -- to pass a budget poses additional hurdles in a state that already is highly politically divided.
"They're still expecting an $8 billion deficit, so there's going to be some really difficult decisions that will have to be made by the Legislature and the governor," said David Blair, senior analyst focusing on California at Nuveen Investments.
"What exacerbates that will be the presidential election next year, which will create a further politicized environment."
Mark McCray, municipal bond manager at Pimco, which manages more than $10 billion in municipal bonds and about $2 billion from California, also is remaining somewhat bearish on the investments.
His fund has not increased exposure to the general obligation bonds in the past year, saying the spread in yields between California and higher-quality triple-A bonds, which is about half a percentage point, isn't worth the additional credit risk.
McCray noted that if the Legislature had been unable to pass the $99 billion budget, California might have faced a severe cash flow crisis that could have prompted another downgrade to junk-bond status. That risk still remains given the state's expected deficit for next year.
"There will be plenty of [buying] opportunities in the future. I wouldn't be in any hurry to see any kind of improvement in the credit quality," McCray said.
"The size of the budget deficit is unprecedented and the amount of political rancor is also unprecedented."