Pimco Says California Yields May Revisit 2009 Peak on Deficits

Bloomberg reports:

California, the world’s eighth-largest economy, faces a $20 billion hole in the budget during the next 17 months. With its cash dwindling, the government may need to issue IOUs for the second straight year unless Governor Arnold Schwarzenegger and two-thirds of the Legislature can agree on a fix. Once the budget is balanced, the state is poised to sell billions of dollars of bonds after flooding the market with $36 billion in debt last year.

California’s credit default swaps, insurance contracts that are generally used to protect against default, have risen 97 percent since late October to $314,000 to protect an investment in $10 million of bonds. The state has $73 billion of general obligation debt outstanding, according to Treasurer Bill Lockyer, who has repeatedly dismissed any suggestion the state may not make required payments.

A taxable California bond that matures in 2039 traded on Feb. 2 for an average yield of 7.70 percent, 3.14 percentage points more than 30-year Treasuries. On July 1, the day before the state issued IOUs, the difference widened to as much as 4.03 percentage points, according to data compiled by Bloomberg.

Kenneth Naehu, who invests $2.5 billion for Bel Air Investment Advisors in Los Angeles, sold California bonds late last year as he saw deficits mounting -- and says he’s not ready to buy back in yet.

Naehu, 43, is among investors including Newport Beach, California-based Pacific Investment Management Co. and Thornburg Investment Management in Santa Fe, New Mexico, forecasting that the state’s yields -- which move inversely to prices -- may increase relative to other municipal bonds because of the financial strains. Pimco, the world’s biggest fixed-income manager, predicts the yield on 30-year debt may rise above 6 percent, the highest since last summer’s fiscal crisis.

Couple this with the huge federal debt that will have to be issued this year, that will push up all rates, and California general obligation debt has to be one of the best bond shorts on the boards.