Municipals

California: A State Like No Other

Oct 04, 2024

Key takeaways

It’s no secret that value has been restored in bond yields, and municipal bonds are no exception – particularly for California residents who can reap the tax– exempt benefits of bonds issued by the state.
The BlackRock Municipal Analyst team has identified several areas of opportunities and risks for investors when investing in California municipal bonds.
BlackRock California Municipal products can capitalize on opportunities the team has identified within the market.

The Golden State has taken a remarkable turn in terms of its financial health in the past decade. Balanced budgets and improved cash flows have led to credit rating upgrades and stable outlooks. Our credit team has identified several areas of opportunities, however, there are some areas of risks we are keeping a watchful eye on as well.

Boom or Bust Economy

Advantages:

California’s economy is unmatched among U.S. states: It is large and diverse, representing 14.6% of U.S. GDP (making it the 5th largest “country” economy in the world).
Strong cash flow management and liquidity: The state has demonstrated fiscal discipline with an impressive record of on-time budget successes and a focus on paying down budgetary borrowings.
Manageable debt burden: Net tax-supported debt as a percentage of state GDP is 2.9%, which compares favorably to the national median of 2.1%.
Regional opportunities: Our propriety economic heat map highlights regional disparities. For example, Southern California continues to see healthy economic trends, while benefiting from robust tourism and plans for return to office.

California County Heat Map

^{Economic Model Based on: Employment, Poverty, Wealth Levels, Home Prices, Building Permits}
^{Source: BlackRock, Federal Housing Finance Agency, Bureau of Labor Statistics, Consus, Equifax, Zillow, Bureau of Economic Analysis; As of June 1, 2024}

Risks:

California’s job growth continues to lag the nation: The state has an unemployment rate of 5.2% compared to the national average of 4.3%.¹
Out migration from California to lower cost states: For the second year in a row, U-Haul data showed that California ranked last for one way U-Haul trips, while Texas and Florida ranked first and second, respectively, in both years.²
Regional risks: Areas such as San Francisco have large exposures to troubled commercial real estate and have struggled with their recovery post pandemic. Growing budgetary expenditures threaten the city’s ability to provide services for residents.
Large pension and retirement liabilities: While funding ratios have improved due to solid returns driven by a strong equity market, OPEBs remain a large and growing concern.
Reliance on high income earners: Due to the stock market declines, the state’s high reliance on PIT led to large deficits as the percentage of revenues from the top 1% of taxpayers fell from 50% to 39% for the 2022 tax year.³

Estimated revenue chart for fiscals 2023 and 2024

Strong retail demand for California bonds has resulted in tight credit spreads, which are currently not reflecting the fundamental picture. This means investors are not getting paid for the risk they are taking on by investing in general obligation bonds issued by the state. Instead, the BlackRock Municipal Credit team prefers revenue bonds over tax-backed bonds in the state.

Areas of Opportunity:

Pre-paid gas bonds: Investments across this sector, backed mainly by large banks, offer wide credit spreads, high yields, and low duration.
Sales-tax-supported regional transportation agencies: These credits, such as the Los Angeles County Metropolitan Transportation Authority, continue to show strong margins of debt service coverage protection and conservative use of leverage. This should make these dedicated-tax bonds a defensive vehicle in the next downturn.
Transportation bonds: There are several opportunities here. We prefer large airports and seaports, given their prominent position as international gateways to travel and
trade.
Essential service providers: This sector benefits from dedicated monopoly fee structures. These include large water & sewer and public power entities that offer diversification and liquidity.
Select California hospitals: We seek out hospitals that benefit from implementation of the Affordable Care Act with Medi-Cal expansion and a federal match of the provider fee program. We look for proactive and disciplined management, multi-state systems, market leading standalones, and children’s hospitals.

The state is not without its risks and budgetary complexities. Our goal is to capture value while avoiding the pitfalls that can come with choosing the “wrong” credits. Our dedicated 15-member analyst team remains vigilant in analyzing the risks and opportunities across issuers and credits on behalf of our shareholders to ensure BlackRock portfolios are based on critical thinking and populated with our best ideas.

California bond yields remain elevated, giving investors the ability to lock in yields at the highest level in a generation.

^{Bloomberg California Municipal Bond Index, yield to worst as of 8/31/2024}

California investors may have the most to gain from the tax-exempt nature of municipal bonds.

^{*Showing the Bloomberg California Municipal Bond Index as of 8/31/24, 2:09pm EST. Tax rate includes maximum 37% federal income tax + 3.8% Affordable Care Act investment income surtax + 13.3% CA maximum state income tax, adding up to 54.1% combined}

Active Management in Municipals allows you to take advantage of opportunities in the California Municipal Market

The team has opted for a barbell approach – pairing front end yield curve exposure with longer dated maturities while avoiding the inversion along the intermediate portion of the municipal curve. Within the state, the team prefers revenue bonds over GOs to capitalize on market inefficiencies and take advantage of relative value.

Chart of sector specific opportunities exist

^{Source: BlackRock, ICE. As of 9/6/2024}

With these strategies in mind, active management has paved the way for outperformance in 2024 so far.

Chart of macmx vs municipal index performance

^{Source: BlackRock as of August 31, 2024. The performance quoted represents past performance and does not guarantee future results. Investment returns and principal values may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. All returns assume reinvestment of all dividend and capital gain distributions. Refer to www.blackrock.com to obtain performance data current to the most recent month-end.}

Additionally, BlackRock offers a wide variety of California specific products including the actively managed BlackRock Short-Term California Muni Bond ETF (CALY), iShares California Muni Bond Index ETF (CMF), several actively managed closed-end funds and customizable separately managed accounts.

For municipal investors outside of California, be sure to check out our flexible suite of actively managed municipal products including: BlackRock Strategic Municipal Opportunities Fund and BlackRock New York Municipal Opportunities Fund.