Why you shouldn't buy California GO bonds

(MoneyWatch) COMMENTARY As a Missouri resident I would never buy a state of California bond, even if it were a AAA-rated general obligation (GO). The reason is that the high state tax rate in California increases the demand for double tax-free income for the state's residents, suppressing yields. However, for California residents, highly-rated state GOs once made sense, at least in an era when they were highly rated. The problem today is that California's GOs are no longer highly rated. The current Moody's (MCO) rating is A1. While still considered to be above-average in credit worthiness, an A1 rating is only the fifth-highest ranking.

California's problems are well known. The failure of the state's elected officials to seriously address its fiscal problems has even led to comparisons with Greece. However, Greece's CCC rating is in the "junk" category -- 11 notches below California's. And California's debt-to-GDP ratio is substantially lower. Clearly the California and Greek situations are quite different. But there are some similarities that should send up caution flags for investors.

Like the Greeks, California politicians promised benefits that could never be paid based on any realistic assumptions. In an era when we're living longer, they kept promising higher benefits and allowed public employees to retire earlier and earlier, compounding the problem. The state has made matters worse in several ways. First, they keep using bookkeeping gimmicks to push the problem forward, without ever addressing the real issues, leaving them to be solved by the next group of politicians.

Second, the state uses an unrealistic assumption on the rate of return on pension plans. High rate-of-return assumptions push the pension plan system to take more risks. The financial crisis provided a reminder of why that's a bad idea. The result has been an increasing problem in terms of underfunding.

Third, they have continuously made unrealistic revenue assumptions. The state keeps raising taxes to make up for the shortfalls, but revenues persistently fall short of projections. One reason is that high net worth people and corporations are fleeing the state for more tax-friendly pastures, putting the state in a vicious cycle.

Yet Governor Jerry Brown proposes even more taxes, which will only worsen the problem. He now wants voters to approve the highest sales and income tax rates in the nation. The state's top tax rate would leap from 10.3 percent to 13.3 percent for seven years. Sales taxes would increase to 7.75 percent on average. Brown claims that these tax hikes would generate another $9 billion in revenues. Just as past projections have failed to generate the revenue expected, the odds are high this will fall short also because individuals change behavior. They move, they shelter income, and if you raise rates high enough they even stop reporting it, going underground.

In fact, Brown recently announced that tax collections were again coming in well below projections. Thus, the state faces a $4 billion deficit by the end of its current fiscal year. Even worse is that if they do nothing, by the end of the coming fiscal year the deficit would grow to $16 billion -- and that's without taking into account the unrealistic assumptions mentioned above. Their budget also optimistically assumes large revenues from Facebook's (FB) recent initial public offering.

The problem is so bad that one has to even begin to wonder if California's problems could impact the rest of the country. In an interesting recent New York Post article, Kyle Smith made these observations:

• California contains about one-third of the nation's welfare recipients, despite having 12 percent of the nation's population.
• Despite its problems, the state is planning a high-speed rail system that will cost an estimated $68 billion, including $4 billion on a section The Los Angeles Times dubbed a "train to nowhere."
• Its pension costs for public employees, 85 percent of which are unionized, rose 2,000 percent in the first decade of this century, which is only 1,976 percent more than revenues increased.
• A CEO survey in April ruled that California was the least business-friendly state in the U.S.
• In 1999, the state allowed government workers as young as 50 to retire on 90 percent of salary they earned in their final year, when they would ramp up the overtime. In order to cover these commitments through the CALPERS investment fund, the Dow Jones Industrial Average would have to be over 25,000 by now.
• Pension and health-care spending for retirees are set to triple this decade. More than 12,000 state and local workers are collecting more than $100,000 a year in pensions. Even convicted felons can collect pensions.

As Smith rightly points out, Greek and Californian politicians made the same mistakes. "They wanted union backing so badly that they promised far more than they could ever deliver," he writes. "They knew that they'd be long gone before the crisis kicked in, or maybe it would solve itself. Either way, they didn't care. They were happy to use tomorrow's seed corn to buy themselves power. California's pension plans face a $500 billion hole in unfunded promises."

Although Brown says he wants to overhaul the cost structure of California by raising the retirement age, it seems unlikely he will be able to push these reforms through the state's Democratic legislature (some would say a legislature that has been bought with union funds).

The bottom line is this: Greece was a bubble that was just waiting to pop. While there are some similarities, California's situation is very different, as reflected by both the investment grade rating its bonds still carry and the spreads its bonds trade at versus similarly rated bonds. The state still has time to address these problems, and the likelihood of a default on the bonds in the near future is remote.

With that said, what should you do as an investor?

Before considering if the risks of investing in California's GOs are worth taking, remember that the main role of fixed income in your portfolio should be to provide stability, lowering the risk of the overall portfolio to an acceptable level. That means not taking risks in search of higher returns. With that caveat, the following suggestions are offered:

• On 10-year bonds, California's A-1 rated GOs provide about 0.9 percent more yield than a AAA-rated bond and about 0.6 percent more than a AA-rated bond. On three-year bonds, the incremental yields are just 0.5 percent and 0.3 percent, respectively. Are the higher yields worth the risk? Will you be able to sleep well if the situation deteriorates? Can you stand the loss of principal if there is a default of some kind? If the answers are "no," you should at least consider selling your existing holdings. And you should certainly avoid buying more.
• Since the longer the maturity, the greater the risk of a default, consider holding bonds where the remaining maturity is short term (say three years or less), but selling ones that have a longer remaining term.
• Limit any holdings to a very small percentage of the portfolio, perhaps 5 percent or less.
• If you're holding existing bonds and are considering selling, keep in mind that trading costs could be high if the holding is a small one (say less than $100,000). That cost should be considered in your decision.

As a concluding thought, consider these words of wisdom I was given at a credit-risk training course for bank lending officers: It takes an awful lot of interest to make up for unpaid principal. That's why you shouldn't be adding new California GOs to your portfolio. For any risk-averse investor (and that almost certainly includes you), the value of the incremental return seems disproportionate to the pain if there were to be a default. Thus, even though the odds of a default in the near future are very low, the consequences of being wrong are likely to be too high to make the risks worthwhile.