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Municipal Bonds

California’s sunny financial conditions continue

Lori A. McDonald
Senior Research Analyst
Hiker gets to see downtown view from a hill

The state of California started 2022 with historic levels of reserves. Since the last recession, it has repaid billions of dollars in budgetary borrowings, debt and deferrals; deposited surplus revenues into a rainy day fund; paid down other post-employment benefits (OPEB) and begun prefunded pensions. The state is better prepared to face the economic impacts of a potential recession.

California passed budgets on time over the last 12 years and built its rainy day fund.

Institutionalized changes helped strengthen the state’s credit profile

Aside from general economic resurgence, the state’s credit profile improved with the following positive institutionalized changes:

Proposition 25 (2010) reduced the voting requirement to pass a budget in the California legislature from a super majority (two-thirds) to a simple majority (50%) and would dock lawmakers’ pay when the budget is late, incentivizing on-time budget passages.

Proposition 2 (2014) is a more stringent rainy day fund aimed at smoothing out the state’s revenue volatility by requiring 1.5% of General Fund revenues plus any capital gains taxes that exceed 8% of General Fund revenues be deposited in the budget stabilization account (the rainy day fund) and be used to repay the state’s budgetary borrowing and make excess payments toward state pensions and retiree health costs. Debt repayment is required through 2029, at which time the debt repayments become optional.

Proposition 30 and Proposition 55 (2012). Proposition 30 temporarily increased sales taxes by 0.25% to 7.5% from 01 Jan 2013 to 31 Dec 2016, and personal income taxes by 3% to 13.3% for the top tax bracket from 2012 to 2018. Passed in 2016, Proposition 55 extends the personal income tax portion of Proposition 30 for 12 additional years (through 2030).

Because of these changes, the state has been able to pass budgets on time over the last 12 years and build its rainy day fund, while also paying down its debts and liabilities. Since the Great Recession, the state has capitalized on the improved economic recovery and taken steps to prepare itself for the next economic recession.

The enactment of Proposition 2 allowed the state to build its total reserves from unfunded in 2009 to $16 billion, or 10.4% of General Fund revenues, by FY20. These actions have better prepared the state to handle a recession and earned rating upgrades to Aa2 by Moody’s, AA- by Standard and Poor’s and AA by Fitch.

The state’s General Fund posted a $17.4 billion net surplus in FY20.

Cash management tools are available

In addition to the measures taken to balance the budget, California has many tools available to help manage cash flow disruptions. The state can access more than 800 of its 1,400 separate funds to borrow for cash flow needs totaling $49 billion as of 30 Jun 2021. It can also issue revenue anticipation notes (RANs) or revenue anticipation warrants (RAWs) in order to finance cash flow needs.

RANs are typically used to smooth the timing difference between when revenues are collected and when bills are due. RAWs are issued in the absence of a budget. California has not issued RANs since FY15 and there are no plans to issue RANs through FY22-23. The state historically relied heavily on RANs to manage cash flows, so the lack of issuance demonstrates the state’s improved financial health.

And if needed, the state can issue registered warrants (or IOUs), which it did back in 2009. However, the state is no longer allowed to issue long-term debt to fund operating deficits with the passage of Prop. 58 (2004).

The 2022 budget includes a revenue windfall

The state of California failed to file its annual report for FY21 by the 01 Apr 2022 continuing disclosure deadline. The delay, according to the State Controller, is a result of “the cumulative impact of delays in the completion of Annual Comprehensive Financial Reports for the three previous fiscal years, which was due to a large number of State Departments transitioning from several separate legacy accounting systems to a new statewide accounting, budget, cash management and procurement information technology system, contributing to delays in the state departments providing information to the State Controller necessary for the preparation of the Annual Comprehensive Financial Report for such fiscal years.”

The FY20 report was released 26 Jan 2022 and contains the most recent audited financials available for the state of California, therefore this paper references the FY20 numbers.

Despite the pandemic, the state’s General Fund posted a $17.4 billion net surplus in FY20, equal to 11.2% of General Fund revenues. Strong economic conditions helped California achieve the surplus, given that 95.9% of General Fund revenue is derived from the state’s largest three taxes: personal income taxes, sales and use taxes and corporation taxes. In addition, California received federal pandemic related aid, but this aid is held outside the General Fund in a separate Federal Fund. General Fund tax revenues came in at $15.4 billion, or 11% ahead of prior year and 6.8% higher than estimates. Expenditures came in at $9.4 billion or 7.3% higher than FY19, but 1.0% lower than budget.

When the 2020-21 Budget Act was enacted in June 2020, the legislature had to solve for a $54 billion deficit for FY21 (approximately 40% of General Fund spending), reflecting a projected decline in income and increased costs related to COVID-19. The state drew down a portion of its reserves, borrowed from internal funds rebuilt over the last decade, deferred money to K-14 education, suspended program expansions from prior years’ budgets and relied on federal CARES Act funding. The state has relied upon many of these methods in previous recessions to balance the budget.

However, by the time budget planning came around for FY22, the state was projecting a $47 billion budget surplus for FY22 due to significantly higher revenues than were estimated at the time of the 2020-21 Budget Act. Revenues were nearly back to pre-pandemic levels and state costs did not rise as drastically as anticipated, resulting in a windfall.

Spending of the windfall was largely geared towards one-time or temporary disbursements on housing and homelessness, and additional discretionary COVID-19 aid; depositing money in the Special Fund for Economic Uncertainty; expanding tax incentives for builders and small businesses and tax refunds to low income residents; and repaying special loans made in FY21 and additional payment to CalPERS. Additionally, the proposed budget includes funds to pay down K-14 deferrals made in FY20 and help reopen schools.

On January 10, 2022, Governor Gavin Newsom presented his Governor’s 2022-2023 Budget totaling $286.5 billion. The General Fund budget proposal totals $213.1 billion, up 1.5% over the prior year’s revised budget, and includes a projected $45.7 billion surplus.

State revenues increased due to four primary factors: a healthy economic recovery, a greater share of wage gains contributions from high-wage sectors, a better-than-expected stock market and higher inflation.

The surplus includes $20.6 billion for discretionary purposes, $16.1 billion for K-14 education and $9 billion for reserve deposits and supplemental pension payments. The budget contains new funding for health care, homelessness, schools, COVID-19 and climate change. The budget projects reserves of $34.6 billion: $20.9 billion in the budget stabilization account (BSA) (rainy day fund), $9.7 billion in the public school system stabilization account (PSSSA, education reserve), $900 million in the safety net reserve (protect safety net services during economic downturn) and $3.1 billion in a special fund for economic uncertainties. The budget projects the BSA in FY23 to meet the 10% of General Fund tax revenues constitutional maximum and as a result, any excess revenues that would have been deposited into the BSA must be spent on infrastructure.

On 13 May 2022, Governor Newsom released his May Revision to the proposed 2022-23 budget. It projects California’s economy will continue to expand, but at a slower pace than originally proposed in January 2022. Factors now limiting California’s economic growth include: global supply chain bottlenecks, international economic sanctions in response to the Russian invasion of Ukraine, tighter monetary policy and persistently high inflation.

Despite these limiting factors, the May Revision projects total General Fund revenues and transfers to be $219.6 billion, up 11.6% from $196.7 billion forecasted in January 2022. The May Revision General Fund budget for FY22-23 totals $227.4 billion, or 8.3% higher than in January 2022. The May Revision reflects $49.2 billion in discretionary surplus with 94% expected to be spent on one-time projects. Total Reserves are projected to end FY23 at $37.1 billion: $23.3 billion in BSA, $9.5 billion in the PSSSA, $900 million in safety net reserve, and $3.4 billion in the traditional General Fund reserve.

Proposed budget additions include a $400 rebate to households based on number of vehicles; temporary reduction of the diesel sales tax rate; subsidized child care; and assistance for rental housing and outstanding utility bills from COVID-19. It also allocates additional funds to help address the statewide drought; improve energy systems reliability over the next five years; and provide incentives for climate positive projects. Supplemental payments toward the state’s pension liabilities are estimated at $3.4 billion in 2022-23 with another $7.6 billion projected over the next three years. Lawmakers’ final approval is required by 15 June, with the governor signing by 30 June.

Where is the state today?

Despite the expected decline in revenues due to the pandemic, preliminary numbers show the state continues to outperform budget estimates in the FY22-23 budget. According to the State Controller’s Fiscal Year-to-Date 30 Apr 2022 State Cash Report, total General Fund revenues came in at $35.4 billion or 21% ahead of the FY 2023 governor’s budget and $27.2 billion or 15.5% ahead of FYTD 30 Apr 2021. The outperformance is due to increased tax revenues from the three largest taxes: personal income taxes came in 21.9% above budget, sales taxes 7.8% and corporate income taxes 43.7%.

FYTD 30 Apr 2022 expenditures came in under budget by $14.8 billion or 7.5%, which indicates an outperformance of plan and a substantial surplus. The personal income tax outperformance was due to the state’s progressive income tax structure, which is more heavily weighted toward high-wage earners who generally lost fewer jobs from the pandemic versus blue-collar workers. Additionally, the stock market was higher than anticipated when the budget was approved.

California sponsors two retirement systems: the California Public Employees’ Retirement System (CalPERS) and the California State Teachers’ Retirement System (CalSTRS). California has made some progress to address its unfunded liability of the state pension plans.

In September 2012, the California Public Employees’ Pension Reform Act (PEPRA) eliminated contribution holidays and retroactive benefit increases, while prohibiting air time, increasing current employee contributions, lowering defined benefit formulas and placing compensation limits on CalPERS members.

The state has also made additional supplemental pension contributions to both CalPERS and CalSTRS, in addition to the required contributions during strong operating years. Additionally, AB1469 was passed on 24 Jun 2014, intended to eliminate the CalSTRS unfunded liability by 2046 by requiring increasing contributions each year. CalPERS funded ratio (amount of assets on hand to pay for obligations) was 70.6% for FY20, but CalPERS estimates the funding ratio to improve to 80% in FY21 due in part to a 21.3% investment return in FY21.

CalSTRS funded ratio was 67% for FY20, up from 66% the prior fiscal year. Fixed costs, including debt service, plus pension and retirement health care (other post-employment benefit or OPEB) contributions, are 9% of total governmental fund expenditures in FY20. This is high compared to New York’s 5.3% but favorable compared to New Jersey’s 12%, Connecticut’s 22% and Illinois’ 17%.

California’s economy is large and diverse

California’s $3.1 trillion economy is the largest in the nation. It accounts for nearly 15% of the U.S. GDP, and on a standalone basis would be the fifth largest in the world, according to the International Monetary Fund (IMF). The state’s real GDP, despite falling 31.4% (seasonally adjusted annual rate) in the second quarter of 2020, has since recovered and surpassed its pre-pandemic level by the first quarter of 2021.

California’s economy is diverse and generally mirrors the nation’s economy, with major components in high tech, trade, entertainment, manufacturing and tourism. The recession resulting from the pandemic increased the state’s unemployment rate from 4.2% as of February 2020 (pre-pandemic), peaking at 16% by April 2020, to 4.8% as of February 2022. Leisure and hospitality sectors saw the largest job losses. But some parts of the economy began to bounce back and stabilize, including sales of single family homes and construction activity.

California recovered close to 89.3% of the 2.8 million jobs lost in March and April 2020 between May 2020 and March 2022. This is just below the nation’s recovery of 92.8% of 22 million jobs lost.

California is an active issuer of municipal debt

California is the nation’s largest issuer of new municipal debt with issuance totaling $86 billion in 2021, according to The Bond Buyer. This accounts for 18% of 2021 issuance nationwide. The state issues two types of debt: general obligation (GO) and annual appropriation (lease revenue).

California state GO bonds are rated Aa2 by Moody’s, AA- by Standard and Poor’s and AA by Fitch. GO debt must be voter approved in a general election prior to issuance. Debt service payments enjoy a priority payment status from money in the General Fund, second only to payments to the public school system and public institutions of higher education. Lease payments that support various lease and appropriation bonds are also considered priority payments, but are lower on the list of priorities.

Under California law, GO debt service payments are considered a continuous appropriation, which means they get paid with or without a formal appropriation by the legislature or an enacted budget. Though not as strong, appropriation bonds are also continuously appropriated with prior approval from the Department of Finance, indicating that sufficient funds are available for payment of debt service.

The debt load is large but manageable

The state of California has the nation’s largest amount of tax-supported debt outstanding at $84.4 billion in 2020, according to Moody’s. However, on a per capita basis, the state’s debt burden is eleventh highest of all 50 states at $2,144 versus the Moody’s median of $1,039. On a personal income basis, California was sixteenth highest in the nation, at 3.0% versus Moody’s median of 1.9%.

Net tax-supported debt in relation to the size of the state’s economy ranked it sixteenth, at 2.7% of state gross domestic product, vs. Moody’s median of 2.0%. California’s debt ratio is likely to increase over the next few years, as the state has approximately $32.6 billion of general obligation bonds authorized but unissued and approximately $7.2 billion of authorized and unissued lease revenue bonds as of 01 Jan 2022. Despite the high debt load, total debt service on the state’s bonded debt is manageable and accounts for 4.0% of total governmental funds as of FY20.

State challenges stem from three factors

Many of the state’s fiscal challenges can be directly linked to three main sources: inflexible expenditures, structural governance problems and a volatile and concentrated revenue mix. The previous weakening of California’s credit was sparked by the economic recession, but these inherent risks exacerbated the issues and limited the state’s ability to react to the weakening revenue.

Inflexible expenditures. The state’s initiative system often dictates policy and reduces its expenditure flexibility. Many initiatives constrict revenue but increase or maintain expenditures. For example, Proposition 98 calls for 40% of the state’s General Fund to go toward education, and in the process reduces GO debt service from first to second position in priority of payments. In addition, Proposition 13 limits property taxes and effectively shifts local expenses to the state.

Structural governance problems. For years, the state has dealt with structural governance problems such as its highly polarized political environment often causing bipartisan gridlock and budget stalemates. Also, the state requires a two-thirds majority vote of the legislature to raise taxes. It used to be a two-thirds majority to pass a budget, but Proposition 25 changed the requirement to a simple majority as of November 2010.

A volatile and concentrated revenue mix. Personal income taxes are the largest component of General Fund revenues, accounting for 71% in FY20. California’s income tax structure is steep (rates range from 1% to 13.3%), thus a small number of taxpayers pay a large share of tax revenues. The Franchise Tax Board (California’s tax collection agency) indicates that the top 1.7% of California taxpayers paid approximately 51% of total personal income tax in tax year 2019. Therefore, about 36% of the state’s General Fund revenue depends on 1.7% of taxpayers (Figure 1). In addition to being a concentrated revenue mix, the state’s primary sources are also highly economically sensitive (Figure 2).

Figure 1
Figure 2

This concentration in an economically sensitive revenue stream means equity market declines can quickly impact the state’s finances. Additionally, sales taxes, another economically sensitive revenue stream, accounted for 16% of General Fund revenues for FY20. These factors have resulted in wide and sudden financial and credit swings.

A number of credit safeguards are in place

Despite the state’s inherent risks, a number of safeguards ensure timely payment of GO bond debt service:

  • GO bonds are secured by the full faith and credit of the fifth largest economy in the world.
  • Debt service is a priority payment from the General Fund, second only to support for the public school system and public institutions of higher education.
  • The state of California is not authorized to file Chapter 9 bankruptcy and cannot cease to exist.
  • GO debt must be approved prior to issuance by the citizens of California in a general election, obligating the citizens for repayment.
  • The appropriation to pay debt service on state GO bonds, as set forth in the enabling Bond Acts, cannot be repealed until the principal and interest on the bonds has been fully paid. Debt service on the bonds is a continuous appropriation under the state constitution, meaning there is no need for appropriation from the legislature to pay.

These provisions give bondholders a certain sense of security that debt service will be made.

Looking forward: weathering the challenges

Structural governance changes have helped streamline decisions and improve California’s fiscal position. As a consequence, the state is better positioned to deal with the challenges presented by the pandemic and any future recession. The state has successfully weathered recessionary challenges historically and is expected to continue to do so going forward.

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State of California, Comprehensive Annual Financial Report, Fiscal Year Ended 30 Jun 2020; California State Budget 2020-21, Gavin Newsom, Governor State of California, 29 Jun 2020; California State Budget 2021-22, Gavin Newsom, Governor State of California, 28 Jun 2021; Governor’s Budget Summary 2021-2022, Gavin Newsom, Governor State of California; Governor’s Budget Summary 2022-2023, Gavin Newsom, Governor State of California; The 2021-22 Budget: Overview of the Governor’s Budget, Legislative Analyst Office, January 2021; The 2022-23 Budget: Overview of the Governor’s Budget, Legislative Analyst Office, January 2022; The 2021-22 Budget: California’s Fiscal Outlook, Legislative Analyst Office, 18 Nov 2020; May Revision, Gavin Newsom, Governor State of California, 2022-23; Bureau of Labor Statistics; The Bond Buyer; California Department of Finance, Finance Bulletin, April 2022; California State Controller, Monthly Statement of General Fund Cash Receipts and Disbursements, April 2022; California Franchise Tax Board; State of California Various Purpose General Obligation & Refunding Bonds Official Statement, dated 09 Mar 2022; Moody’s Investors Service, Medians-State debt rose 2.5% in 2020, spurred by pandemic-linked borrowing, 14 Jun 2021; Fast Facts About CalPERS Investment and Pension Funding, February 2022,; CalSTRS Fast Facts, Fiscal Year Ended 30 Jun 2021.

The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance does not predict or guarantee future results. Investing involves risk; principal loss is possible.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. For term definitions and index descriptions, please access the glossary on Please note, it is not possible to invest directly in an index.

Important information on risk
Investing involves risk; principal loss is possible. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurer’s ability to meet their commitments. This information should not replace an investor’s consultation with a financial professional regarding their tax situation. Nuveen is not a tax advisor. Investors should contact a tax professional regarding the appropriateness of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.

Nuveen provides investment advisory solutions through its investment specialists.
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