As one in every of the biggest states when it comes to economic prowess and population, California also happens to be one in every of the biggest issuers of municipal bonds. As such, the state’s bonds could be found predominately in several national municipal bond funds. At the identical, as a high-tax state, California munis are a top draw for investors living throughout the Golden State’s borders. So, when concerns about California’s funds creep into the news, it is sensible for investors to get nervous.

Nowadays, investors are getting nervous: California is facing an enormous budget deficit.

The query is whether or not investors needs to be losing sleep over the news. California has long been a boom or bust economy, and that dynamic is playing out today. Given the state’s history of solving its budget woes, the budget deficit might not be a large concern — but caution could also be warranted.

Growing Budget Woes

California is one in every of the biggest issuers of municipal bonds within the nation, with nearly $675 billion in debt outstanding. With such an enormous amount of debt issued, concerns concerning the state’s fiscal health affect not only Californians but additionally investors taking a look at national municipal bond funds. For instance, the $41 billion iShares National Muni Bond ETF (MUB) has about 17% of its portfolio in California bonds.

So, when news broke that California is now entering its third yr of proposed budget deficits, investors rightly got concerned. All in all, California currently faces a proposed $68 billion budget deficit for 2024-25. This follows budget shortfalls of $44.9 billion for this fiscal yr and $32 billion in 2023.

California’s woes are because of the character of its boom-or-bust economy, specifically how the state generates tax revenues. That revenue mix has continued to shift over time, as this chart from BlackRock demonstrates.

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Source: BlackRock

Today, corporate and private income taxes make up the very best proportion of tax revenues, which is sensible.
California is home to Silicon Valley and diverse tech, media, and other high-profit businesses. Because of this, California encompasses a higher-than-national average of high earners, translating to the state having higher-than-average reliance on personal income taxes to assist pay for its programs, pension, and essential services. In boom times, this translates directly into high tax revenues; the inverse can also be true.

For instance, when the market sank in 2022, tax revenues for 2023 fell by over 25%. The trend of lower market returns has continued into 2023, and now into 2024. Fewer firms went for an IPO after which conducted exit events. Apart from just a few select names, markets have moved sideways while high rates of interest made borrowing dearer. These issues directly affect top earners, with the share of revenues from the highest 1% of taxpayers within the state falling from 50% to 39% for the 2022 tax yr. These taxpayers have limped further in fiscal 2023-2024.

That’s in the event that they are proceed to reside in California. Due to its overall high-tax environment, California features one in every of the very best migration rates of taxpayers fleeing the state for other lower-tax locales, making among the tax losses everlasting.

Despite California’s budget woes, investors have responded in kind. On a complete return basis, which incorporates interest payments, the S&P Municipal Bond California Index is up only 3.31% this yr. Whenever you subtract coupon payments, the return is barely negative.

A Good Long-Term Picture

Nevertheless, the headline figures and worries about California’s debt woes together with its municipal bonds could also be a bit overblown — the state still has loads of levers to tug.

For starters, the state’s debt might not be as large or as bad because it seems. While the number outstanding is important, net tax-supported debt as a percentage of the state’s GDP is 2.9%, whereas the national average is 2.1%. So, California isn’t too far off and continues to be manageable. Furthermore, legislators recently passed a balanced budget for fiscal years 2025-2026. This includes cutting spending, raising revenues, drawing on reserves, and implementing temporary measures to patch the holes in 2024’s budget. These fixes drop the budget deficit right down to just $2 billion.

At the identical time, the Golden State’s rainy-day fund has grown to the utmost allowed under California law at $24 billion. This offers the state some wiggle room to pay its deficits while it waits for a boom economy to occur again.

Speaking of that boom economy, it might be here before later. Tech layoffs have began to diminish, while the Fed’s path to lowering rates of interest has helped boost the sector’s fortunes. Latest forays into artificial intelligence have also began to learn tech firms and the state’s coffers. Meanwhile, California’s Proposition 13, which caps the quantity that a property’s taxable value can only increase by 2% annually, has continued to supply a gentle source of money although property values have suffered lately.
The result’s that California isn’t as bad off as investors might imagine. Credit standing agency Fitch believes that California’s budget moves and issues are temporary, and it continues to support an investment-grade ‘AA’/Stable Issuer Default Rating.

High Potential Yields

So while California is facing some budget woes, those woes might not be as bad as first perceived. Risks reminiscent of the state’s higher-than-average unemployment rate and a few resident migration issues are there, ultimately, most analysts imagine that California will make it through the present malaise and move on to greener pastures.
This provides an interesting value in California bonds.

Spreads remain tight in California munis. Nevertheless, the present woes and barely negative returns have boosted yields for the Golden State’s debt. Without delay, the yield-to-worst on the Bloomberg California Bond Index is 3.24%. That’s not bad in any respect and is barely above the national average. The taxable equivalent yield jumps to 7.06% for top earners in California (37% federal income tax, 3.8% Reasonably priced Care Act surtax, 13.3% CA maximum state income tax for a complete of 54.1% in taxes). For non-California residents, it still offers a formidable after-tax yield of over 6%.

Because of this, investors will want to consider adding California to their bond portfolios. National funds contain plenty of exposure to the Golden State and will be all you wish. Nevertheless, for investors who seek value, several ETFs exist offering direct exposure to the state’s IOUs.

California Municipal Bond ETFs

These ETFs were chosen based on their ability to supply low-cost exposure to the California municipal bond market. They’re sorted by their YTD total return, which ranges from 2.8% to 4.1%. They’ve expense ratios between 0.08% and 0.65% and assets under management between $25M and $2.8B. They’re currently yielding between 2.7% and three.75%.

Ultimately, California’s fiscal issues are troubling, not less than on the surface. Big headline deficits could be scary for a lot of investors. Nevertheless, digging further into California’s funds, budget measures, and historical economic data, we will see that things might not be too bad in spite of everything. That enables investors to purchase the Golden State’s bonds at a reduction and high yield.

Bottom Line

California is one in every of the biggest economies and in addition one in every of the biggest municipal bond issuers. With fiscal woes beginning to take hold, it’s easy to grasp why investors are concerned. But those concerns could also be overblown, not less than within the near term. To that end, California bonds may offer an enormous yield at an enormous discount.