(Bloomberg) -- Municipal bond investors seem to have brushed off news that California’s budget has gone from a record surplus recently to its largest deficit ever at $68 billion.

An index of California bonds showed yields trading below those of top-rated debt after the state’s budget adviser said tax revenue had plummeted below what was expected, more than doubling the budget shortfall from a year ago. 

That’s because demand for California bonds that wealthy residents use to shield their income from taxes is outweighing concerns about the looming fiscal crisis facing the most populous US state. Put simply, high-tax rates in California are more concerning than the budget hole. 

“I don’t think California credit spreads will react to the shortfall,” said Adam Weigold, head of the municipal fixed income team at Manulife Investment Management. “Between sky-high state tax rates, limited supply and overall positive technicals for California paper, I wouldn’t expect any trade-off of California bonds relative to the overall market anytime soon.”


That wasn’t always the case. California used to be one of the worst rated states in the US, with the yield penalty investors demanded on bonds sold by the state and its localities soaring to as much as 170 basis points above top rated bonds in 2009, when the state resorted to IOUs to pay bills. But a series of budget reforms, tax increases and fiscal discipline starting under former Governor Jerry Brown restored some fiscal credibility on Wall Street. 

In high-tax states like New York and California, wealthy investors have propped up municipal bond valuations. In November, high absolute yields increased the value of the tax-exemption on municipal bonds to their highest level in 20 years, according to strategists at Bank of America Corp. 

“I really don’t see California spreads getting meaningfully wider,” said Mikhail Foux, head of municipal strategy at Barclays Plc. “I am a believer in market technicals, and at current levels the market tone is strong, and technicals are supportive.”

Still, the $68 billion projected shortfall is a stark reversal for California, which enjoyed remarkable surpluses in the wake of the pandemic as the stock market rallied on the back of massive stimulus from the federal government. That delivered windfalls to wealthy residents who account for a large chunk of California’s income tax-revenue. 

California is rated AA by Fitch Ratings, AA- by S&P Global Ratings and Aa2 by Moody’s Investors Service. The state has about $70.3 billion of general obligation bonds outstanding, with more authorized but not yet issued, according to the state treasurer’s office. 

California has long been prone to booms and crippling deficits because of the sensitivity of its revenue to financial markets. High interest rates have hit top earners in the state hard, echoing challenges faced during historical market downturns. 

The state’s Legislative Analyst’s Office said in a report released Thursday that tax receipts fell $26 billion short of earlier estimates during the last fiscal year and forecast a cumulative $155 billion deficit through 2028. 

“The LAO report is a warning that revenues have slowed and that the economy is slowing, but it’s really important to remember that if you go back to 2019, their general fund budget was $144 billion, said Karen Krop, senior director of US public finance at Fitch. “In 2024, even with lower anticipated revenues, their revenues were estimated at $208 billion.” 

Governor Gavin Newsom in January will present his budget proposal for the upcoming fiscal year that begins in July 2024. He and state legislators reached a $311 billion budget deal this past June for the current fiscal year which covered a $32 billion shortfall and at the time they set aside $38 billion of reserves. 

“California knows that it gets hit hard when the economy turns, which is why they’ve been hoarding reserves and been careful about spending during the past couple budgetary ‘boom’ years,” said Dora Lee, director of research at Belle Haven Investments.

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