Top of the Morning: Munis - California compendium

Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today we are going to focus back in on the municipal bond market, specifically highlight the California compendium note from the UBS Chief Investment Office.

Now this was authored back on February 24th and is available for you now up on UBS.com slash CIO. And of course for our clients listening in, please just contact your UBS financial advisor if you would like to receive the California compendium directly. Joining me here for the conversation today, the two contributors to the piece, we have joining us today Ted Galgano and Janine Lennon, senior municipal strategists from the UBS Chief Investment Office.

So Ted, Janine, I know you have a lot you want to cover with our listeners and clients on today's episode, so welcome back. And Ted, let me turn it over to you. Great, thanks Dan and good morning everybody and thanks for tuning in.

As Dan mentioned, we are going to focus our podcast on the most recent California compendium, which was again published on February 24th. The report highlights 15 of the Golden State's largest issuers with over 200 billion in combined debt. With that, let's bring in Janine and ask her to touch upon some of the report's highlights.

Good morning and thanks to everyone for listening in today. Certainly, as you referenced, the report includes 15 of the state's largest issuers of debt, which also tend to be some of the most widely held names by our clients and or some of the most frequently traded issuers in the market. We update this compendium each year as we've received positive feedback regarding a one-stop report for California residents that hold a majority of their investments in-state given the tax advantages of owning California paper.

Holistically, looking at the 15 issuers, 12 of them are rated in CIO risk categories 1 and 2, reflecting lower risk, and 3 are assigned to CIO risk category 3, reflecting moderate risk levels, as outlined in the report. And that includes Los Angeles Unified Schools and both the electric and water bonds issued by the Los Angeles Department of Water and Power. Okay, thanks Janine for that overview.

Seems as though certainly from a big-picture standpoint, California issuers are well positioned to meet their obligations. So with that, maybe can you spend some time discussing the big behemoth of the state of California and the headlines surrounding their fiscal matters? Certainly, happy to.

California is often in the headlines, but coverage often kicks up around budget season. This year, we also have the November election, where residents will vote for a new governor to replace the term-limited Gavin Newsom and the prospect of a possible wealth tax, which we will get into a bit later, among several other statewide initiatives. But focusing on the state's finances for a minute, California continues to experience structural operating deficits, albeit smaller from the last two years, with expenses growing faster than revenues.

The governor's recently proposed fiscal year 2027 preliminary budget indicates that revenues have exceeded expectations by $42 billion for the current fiscal year that ends June 30th, which has been driven by higher stock market levels and an improved economic outlook. Despite such revenue growth, though, the state has still identified a $2.9 billion shortfall for fiscal year 2027, which increases to $22 billion in 2028. While negative, the deficit is an improvement from the prior two years, where the state withdrew a combined $12.2 billion from reserves to help fill past deficits.

That said, the state still expects to retain about $23 billion in reserves to help tackle out-years deficits by the end of the budget cycle, which will help to provide financial flexibility looking ahead. Now, despite its ongoing structural imbalance and the uncertainty surrounding federal policy and funding, we believe that California's sizable and diverse economy, solid financial reserves, and substantial resources should allow it to manage its budgetary pressures, enabling the Golden State to navigate challenges, in our view. Okay, thanks for that background on the state and its financial flexibility.

It still retains, despite clearly those past deficits. Can you provide us with some context as to whether California has been in this position before, and also how the proposed billionaire tax that we keep hearing so much about stands to impact its credit quality if passed? Sure.

California has been in this position many times before, given the state revenues are cyclical in nature, with personal income tax revenues contributing an above-average 62% of the state's operating revenue. Notably, almost 40% of those revenues are derived from just the top 1% of filers. Now, for some perspective, that's an estimated 176,000 taxpayers out of a state with a population of almost 40 million.

State revenues are thus highly vulnerable to both demographic migration and to financial market shocks, for income that's largely derived from a relatively small group of taxpayers, which can have significant impacts on revenues from year to year. To help stabilize revenues, they've implemented the funding and required maintenance of various forms of reserve funds to help mitigate shortfalls. Now, with such a reliance on the state's wealthy taxpayers to support its operations, we will also be paying close attention to the status of the proposed billionaire tax that you mentioned, and whether or not it receives the required 875,000 signatures to make it onto November's ballot.

For those of you that may not have heard about it, late last year, a citizen-led ballot initiative was introduced seeking to impose a one-time 5% tax on individuals with over $1 billion in net assets. What makes this proposal unprecedented is that it takes worldwide net worth, including unrealized gains, or in other words, taxes of things you own rather than your income. While the proposal faces a challenging legal road, it could have material implications for California's long-term fiscal health and credit quality if it passes, survive litigation, and if a substantial amount of billionaires relocate successfully out of the state as personal income taxes, which the state relies upon, would decline, creating fiscal pressures over the longer term.

Now, to change things up for a second, I think it makes sense to pass the question over to you with regards to your coverage of the Los Angeles Department of Water and Sewer issuers and the recent headlines we've been seeing regarding last year's wildfires. Can you maybe spend a minute giving us a credit update on them given the litigation they're currently facing? Yes, of course.

You know, as everybody is aware, California faces heightened exposure to environmental risks from droughts, wildfire flooding, and seismic activity, just to name a few. Last year, Los Angeles unfortunately experienced the devastating effects of multiple wildfires back in January. From a credit perspective, L.A.

DEWOP, which is the nickname for L.A. Department of Water and Power, was the most impacted given its exposure to litigation associated with the wildfires. So, numerous lawsuits have been filed against L.A.

DEWOP in connection with these fires. The majority of them do not, you know, specifically call for a dollar amount for damages. However, one pending class action lawsuit does assert damages in excess of ten billion dollars, so quite hefty.

So, the master complaint in that lawsuit, you know, alleges among other things that the department failed to properly maintain its water systems for purposes of fighting fires. The complaint further alleges the department chose to design its water system for urban use rather than for wildfire suppression. It also alleges the Palisades fire was foreseeable in light of available data regarding the history of fires in the area.

Now, in CIO's view, L.A. DEWOP has the financial capacity to manage potential liabilities should the utility face a large settlement. So, one of the things it could do is issue long-dated bonds, you know, 30, 40, 50 years, to raise the necessary funds and have the ability to spread that liability out over a very long time period and over a very large customer base.

So, beyond litigation, we believe L.A. DEWOP's risk pricing has permanently shifted due to the need to rebuild damaged assets, strengthen infrastructure against future climate-related events, factors which are likely to increase leverage on their balance sheet and certainly weaken the balance sheet. So, this new paradigm is reflected in current spreads, and therefore, CIO continues to recommend against adding to positions at current spread levels given the downside risk associated, you know, should they lose the outstanding litigation.

Certainly understand that. Thanks, Ted, for providing a credit update on L.A. DEWOP's litigation.

With that, obviously a lot going on in California next year, and we will continue to make sure to follow monitoring events closely and provide updates as the legal, financial, and policy landscapes evolve. For a more in-depth review of any of the 15 issuers, please see the California Compendium published February 24th. Also, thanks to everyone for listening.

Back over to you, Dan. Okay, well, Janine Lennon, Ted Galgano, thank you for joining us here on top of the morning to keep our listeners and clients informed. Again, Ted Galgano and Janine Lennon from the CIO Municipal Research Bond Team here in New York have been referencing the California Compendium.

Again, that was authored on February 24th, and do advise our clients listening in, please reach out to your UBS financial advisor if you would like to receive a direct copy of the California Compendium. From UBS Studios, I'm Dan Cassidy. Thank you for joining us.

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