Bond Markets Shrug Off California Budget Shortfall

Andrew Barber — March 03, 2023

A quick scan of recent headlines concerning California’s financial situation might lead you to conclude that the state’s economy is facing a bumpy road ahead. The bond market is telling a very different story.

A fiscal outlook published in February by the California Legislative Analyst’s Office (LAO) calculated that state tax revenues are almost $23 billion lower than the same period in fiscal year 2021/22 and worse than the estimates included in Governor Gavin Newsom’s budget submitted in January.

The LAO report indicated shortfalls in corporate income and capital gains.

Despite the surprise, the S&P California General Obligation index has underperformed the national benchmark by only 19 basis points this year.

Tom Kozlik, the Head of Public Policy & Municipal Strategy for Hilltop Securities in Dallas, says investors are largely chalking the data up to the base effect.

“One of the critical things to keep in mind is just how strong revenues were in California in 2020,” he adds. “Almost anything is going to fall short of that high a hurdle, and I think that the market understands that, and that's why they are shrugging off negative headlines.”

Bad Memories

“We’ve been here before,” notes Loren Kaye, President of the California Foundation for Commerce and Education (CFCE), a think tank affiliated with the California Chamber of Commerce.

Kaye points out that the state’s current setbacks pale compared to the crisis that gripped state finances between 2008 and 2013.

“We’ve been through recessions or business cycles that resulted in large budget deficits —some of which led to major tax increases and program cuts, but there’s never been the hint of a default.”

In 2009, Governor Arnold Schwarzenegger declared a fiscal emergency as the state grappled with a budget deficit of over $26 billion. Officials in Sacramento were forced to issue IOUs to cover tax refunds and other short-term obligations, and state workers were forced to take furlough days.

California Muni bonds traded down sharply during the second half of 2009 as Fitch lowered the state’s general obligation rating from BBB on cash flow concerns while Moody’s rating fell from A2 to Baa1.

In Kaye’s view, the present downturn is manageable.

“The governor is taking a prudent approach to the economy. He’s slowing down,” says Kaye. “He directed a lot into multi-year budget commitments in 2022, and now he’s backing away from second- and third-year portions of those commitments until the shortfall is stabilized.”

While California’s state finances have come under intense scrutiny, the condition of municipal balance sheets has been largely unreported in national outlets.

“Any heightened concern in bond markets about municipal creditworthiness is without merit,” says Michael Coleman, publisher of

A recognized expert on local government finance within the Golden State, Coleman is the principal fiscal policy advisor to the California Society of Municipal Finance Officers and the League of California Cities.

In recent months, municipal- and county-issued bonds have performed even better than state bonds. According to Coleman, this is warranted. “Fund managers, institutional investors, and rating agencies are correct on rejecting the alarmist talk.”

Buoyant Bonds

According to Hilltop’s Kozlik, the resilience of California’s bond market is part of a larger bullish macro trend in public finance. “I’ve never seen a situation where credit quality was so strong you can see it in the numbers.”

Chris Brigati, Managing Director of Municipal Investments for New Jersey-based Valley Bank, also sees a resilience for California bonds based on structural market forces.

“State and municipal bond markets are at times more reactive to supply and demand factors than other financial assets,” he says. “Retail demand has an outsized impact on the tax-free bond market. Prices can be supported despite short-term changes in underlying fundamentals.”

A slump in new issues may also have contributed. Supply of new California municipal bonds was significantly tighter than long-term averages during 2022, as large surpluses discouraged borrowing among larger school districts and public works departments as well as the State.

Brigati notes that long-term demographic trends continue to favor state and local bond issues. As baby boomers enter their retirement years, they will likely shift an increasing portion of their portfolios into safer, more tax-efficient assets like Muni bonds.

Killing the Golden Goose

While bond markets are calm, some market strategists have raised concerns about future volatility.

Dan Clifton, Head of Policy Research at Strategas, raised concerns in a note to investors following the LAO report.

According to Clifton, the capital gains shortfall was not just the result of Silicon Valley executives holding off on exercising their options.

“We want to be clear that the magnitude of California’s decline is larger than that of other states and cannot be explained by a lower stock market on its own.”

Clifton concludes that regressive tax policies are undermining the state’s finances.

California's highest bracket of earners currently pays state income tax at a rate of 13.3 percent — the highest imposed nationally. According to the most recent data released by the state Franchise Tax Board the top 0.5 percent of California taxpayers, roughly 100,000 people, account for 40 percent of total state income taxes.

In his analysis, Clifton concludes that the state’s current problems will likely lead more high earners to leave.

“The state was too dependent on a small number of taxpayers who are leaving,” he wrote. “Tax policy is killing the golden goose in the Golden State.”

On March 1st, Fitch Ratings assigned a AA rating to $1.8 billion General Obligation bonds to be issued by California.

While noting the state’s many problems, Fitch continues to expect the Golden State to bounce back.

“Growth in California’s economy between the Great Recession and the recent pandemic-related recession was among the strongest of the states. Fitch expects California’s post-pandemic growth to return to this trend.”