California debt cut below ‘A’ grade as budget fight goes on

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California’s bond debt has a rating that starts with a ‘B’ for the first time since 2004, after Fitch Ratings today cut the state to ‘BBB’ from ‘A-minus,’ citing Sacramento’s budget gridlock.

The new rating still is ‘investment-grade’ -- but not by much. After ‘BBB’ is ‘BBB-minus,’ and then the junk rating of ‘BB.’

California has never had a junk rating on its debt, but it’s tempting fate now. Fitch said it is keeping the state on ‘rating watch negative,’ meaning another downgrade is possible.

Fitch, a rival of the better known Standard & Poor’s and Moody’s Investors Service rating firms, is the first of the three to make a move since the state last week began issuing IOUs to cover some of its expenses. S&P and Moody’s also have warned that they may cut their ratings (‘A’ and ‘A2,’ respectively). Fitch’s decision could give them a nudge.

‘The downgrade to ‘BBB’ is based on the state’s continued inability to achieve timely agreement on budgetary and cash flow solutions to its severe fiscal crisis,’ Fitch said, obviously not telling Californians anything they don’t already know.

Still, Fitch said that, by maintaining an investment-grade rating for now, it was indicating that ‘expectations of default risk remain low.’ It acknowledged that, under the state Constitution, bond investors have a priority claim on tax revenue, after education funding.

Fitch had a ‘BBB’ rating on California from December 2003 to Sept. 2004, amid the last big budget mess.

Municipal bond traders said market activity today was relatively quiet. Fitch’s decision is unlikely to shock owners of California’s bonds, although it may drive home that a junk rating isn’t out of the realm of possibility (although many muni market analysts still believe the ratings firms won’t go that low).

Market yields on California general obligation bonds have surged over the last six weeks as the state’s financial situation has deteriorated, but buyers have stepped up in recent days, lured by high tax-free returns.

The annualized yield on 10-year California bonds is in the neighborhood of 5% today, down from about 5.2% at the recent peak but still well above the 4.4% yield of late May.

-- Tom Petruno