California: A State Like No Other

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.

Boom or Bust Economy

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. California is now the world’s fourth-largest economy with a GDP of $4.1 trillion. 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.

Since early April, tariff uncertainty and potential federal policy shifts have fueled stock market volatility, threatening California’s fiscal outlook. The state now faces a projected $12 billion deficit for the fiscal year starting July 1. Volatility may reduce capital gains and personal income tax revenues—California’s largest revenue source. Tariff hikes could also dent corporate profits and tax income. Meanwhile, Medi-Cal costs have surged, requiring $6.2 billion in emergency funding. Governor Newsom’s May Budget Revise proposes spending cuts, revenue increases, reserve use, and borrowing to close the gap. This comes amid a slowing economy, weak labor market, and falling consumer spending. While manageable for now, continued reserve drawdowns could limit flexibility if a national recession occurs.

California County Heat Map

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 proprietary economic heat map highlights regional disparities. For example, Southern California continues to see healthy economic trends, while benefiting from robust tourism and uptick in the return to office trend.
• Attractive yields and tax-equivalent yields: Today, the Bloomberg California Municipal Index yield to worst is approximately 3.92%, which is 0.42% above the long-term average.  This translates to a tax-equivalent yield of 8.54% (based on a cumulative state and federal tax rate of 54.1%**).

Risks:

• Job growth lags the nation: The state has an unemployment rate of 5.3% compared to the national average of 4.2%.¹
• Shrinking population due to migration: U-Haul data shows California is ranked last for one-way trips (5^th consecutive year), while South Carolina, Texas, and North Carolina ranked top three in the country.²
• Regional risks: Urban areas, such as San Francisco, have large exposures to troubled commercial real estate struggling with post pandemic recovery combined with 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 (Other post employment benefits) remain a large and growing concern.
• Reliance on high income earners: Stock market declines led to large deficits as the percentage of revenue from the top 1% of taxpayers fell from 50% to 39% for the 2022 tax year.³
• Subject to natural disasters: Natural disasters, such as wildfires, droughts and mudslides, have been increasing in frequency and severity. Single-site education, healthcare, and development district credits are most at risk given lack of revenue diversity.

California’s revenue sources over time

Strong retail demand for California bonds has resulted in tight credit spreads, which traditionally do not reflect 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 energy 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: We prefer large, major transportation assets (airports, bridges, toll roads, seaports) given their prominent position as international gateways to travel and trade.
• Select California hospitals: We seek entities with proactive, strategic, and disciplined management, a favorable payor mix, solid utilization statistics and scale that can provide leverage in contract negotiations with commercial providers. Given macro pressures around cost inflation, potential changes from Washington and the eventual exchange of commercial reimbursement for Medicare as the population ages, we favor multi-state systems, market leading standalones, and children’s hospitals that have the liquidity cushion to offset these factors.

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 near recent highs, giving investors the ability to lock in yields at the highest level in a generation.

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

Active Management in municipals allows clients 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.

BlackRock recently participated in Brightline West (BLW), the bullet train project between Las Vegas and Los Angeles, $2.5 billion in non-rated private activity bonds, marking the largest high yield municipal bond deal of the year. The bonds offer a 9.5% coupon. BLW aims to operate the first privately owned, all-electric high-speed train in the U.S. by December 2028.

Active sector rotation creates opportunities.

With these strategies in mind, active management has paved the way for outperformance in 2025 so far.

Historical outperformance of MACMX.

BlackRock offers a diverse range of actively managed California-specific municipal investment solutions, including the California Municipal Opportunities Fund (MACMX), the iShares Short-Term California Muni Active ETF (CALI), and several actively managed closed-end funds. Additionally, investors can find the iShares California Muni Bond ETF (CMF) and customizable separately managed accounts to tailor their California municipal exposure.

For investors seeking to potentially enhance their municipal portfolios with additional high-yield exposure, consider the iShares High Yield Muni Active ETF (HIMU). For those prioritizing a short maturity alternative with limited duration exposure, the iShares Short Maturity Municipal Bond Active ETF (MEAR) may offer a solution. Both ETFs seek to provide targeted exposure and income flexibility in the municipal market.

To obtain more information on the funds, including the Morningstar time period ratings and standardized average annual total returns as of the most recent calendar quarter and current month-end, please visit: California Municipal Opportunities Fund

The Morningstar RatingTM for funds, or "star rating," is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods.

Performance data quoted represents past performance and is no guarantee of 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. All returns assume reinvestment of dividends and capital gains. Current performance may be lower or higher than that shown. Refer to blackrock.com for most recent month-end performance.

BlackRock provides compensation in connection with obtaining or using third-party ratings, rankings, or data.

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