John Cummings Portfolio Manager	David Blair Credit Analyst and Portfolio Manager	Bob Fields Product Manager

California is experiencing an unprecedented economic crisis that will likely take years to resolve. And, so far, the result has been a devastating reduction in state appropriations, record unemployment and home foreclosures along with severe political and financial turmoil.

But there is both hope and opportunity in the midst of crisis: Revenues and mortgage defaults are stabilizing, job losses are easing and quality credits among municipalities still exist, particularly utilities, airports, universities and local school districts.

PIMCO’s municipal bond team—John Cummings, David Blair and Bob Fields—recently gave an update on the crisis in the Golden State and discussed their outlook for the state’s fiscal health, including an assessment of the default risk of its municipal bonds and where they are finding opportunities to generate yield. The trio also explains the benefits of PIMCO’s top-down secular outlook and bottom-up credit research in constructing its municipal bond portfolios.

How would PIMCO characterize the current fiscal situation in California, which has driven a lot of headlines recently?

David Blair: This economic downturn, particularly in California, is fairly unique in its severity and duration. As a result, the state's main revenue sources—income taxes, sales taxes and corporate income taxes—have dramatically declined. In prior downturns, you didn’t see all three sources of revenue impacted. It was mostly income taxes. In the last several decades, the state has been able to depend on a nice rebound in the economy following a downturn. California’s revenues have a high beta to the economy because of the progressive nature of its income taxes. So, in the past, when the economy has recovered, the state has done even better. In this cycle, we have seen a dramatic decline in economic activity and state revenues, followed by what we expect to be an anemic economic recovery for an extended period of time. This will result in low revenue growth and fiscal challenges for many years in California.

Has there been any progress made that might indicate these conditions are beginning to move in the right direction?

David Blair: Yes. The massive revenue contraction is moderating, the economy is likely out of recession and the number of job losses—while the state is still seeing them—has decreased. Sales taxes, during July-September, are up about 4% compared to a year ago. But on an overall basis, revenues were still down about 9% during these months. Over this fiscal year, which began July 1, you're likely to see moderate declines compared to last year, helped partly by higher income tax and sales tax rates that the state began to levy this past spring.

On the political front, there have been a lot of ideas for reform discussed but they have been met with resistance from various parties. One of the most dysfunctional aspects of California’s budget system is the two-thirds super-majority vote to required to pass a budget or raise taxes.. This has resulted in an inability to reach consensus on budget solutions, resulting in long budget stalemates and, ultimately, bad policymaking. The budget process needs to be restructured but we're not really seeing a lot of movement on that front. To the extent that we see any impact on policy or the budget going forward, it's likely to be at least a year out. But it's questionable whether we're going to see much movement at all. We’re just not seeing big support for a lot of these ideas among voters.

How will it ultimately play out?

David Blair: California is going to muddle along for several years. In fiscal year 2011 and 2012, the state is going to have large challenges. It will likely address them with a large number of temporary measures, effectively kicking the problem down the road. This means we're looking at four to five years of fiscal challenges. The big risk is that the economy doesn’t pick up very much or we experience a double-dip recession, which could result in an even bigger problem as these temporary measures and the federal government’s stimulus expires.

There's been a glut of new debt issuance in California, which has boosted yields on its municipal bonds. What is the impact of this activity? And is the California muni market saturated?

David Blair: The increasing supply has tended to push up yields, but aside from that we haven't seen any residual change to the California muni market. When yields rise significantly in a short period of time, you tend to attract out-of-state investors. The state has also been marketing its bonds more to foreign investors, thanks partly to the Build America Bond program instituted by the federal government in 2009. The California muni market does not appear saturated as there is a broad base of investors, but the state’s borrowing costs have increased. December and January typically have been two of the biggest months for municipal bondholders to receive potential reinvestment cash, whether it be principal or semiannual interest payments.

What does this portend for the muni market in the short term?

John Cummings: The muni market tends to outperform in December and January. The new issue supply decreases in mid December and tends not to increase until the end of January. The demand for munis typically increases due to the reinvestment of the large Dec 1 and Jan 1 interest payments from outstanding municipals. Yields tend to decline as a result of the decreased supply and increased demand.

What is California's default risk on its state general obligation (GO) bonds which are now rated lowest among all the states?

David Blair: We believe the default risk is low because payments on the general obligation bonds supersede all state expenditures with the exception of K through 14 education expenditures, which is mandated by the state constitution. Essentially, it puts GO bond debt service payments ahead of about 55% of state expenditures. That gives the state a lot of flexibility to deal with cash shortfalls, which it is likely to face over the next year. If the state runs short on cash, then it is the vendors and contractors who work with the state that don’t get paid, not the GO bondholder. It's a higher priority. Debt service on general obligation bonds represents only 5% of expenditures so the state should have the will to make the payment.

Are you buying them right now?

David Blair: We're not buying California general obligation bonds right now because we don’t think they're cheap enough. The default risk is low but the price risk and downgrade risk are high. If they were to get downgraded below investment grade, then that would trigger a lot of negative headlines and selling. We would rather own credits that are stable or improving.

Which credits look attractive or at least remain fairly stable and solvent?

David Blair: We're buying essential service revenue bonds, such as bonds issued by municipal utilities, backed by water and sewer revenues or electric power revenues. Even during recessions, people still need utilities and are willing to pay for them even if you raise their rates. And there's not much competition for municipal utilities providing such essentials.

As a result, we think the Los Angeles Department of Water and Power is attractive. We also like many university issuers, such as the University of California, Stanford University and Pomona College to name a few. Essential airports like LAX and John Wayne Airport are good issuers. We also like certain healthcare providers, such as Kaiser Permanente Health System and Hoag Hospital in Orange County. These credits are a better alternative to owning state credits when you consider the state’s fiscal pressures.

We've also like some of the school district bonds. The school district GO bonds are backed by a dedicated property tax. If the property taxes decline enough, then the school district has the ability to raise tax rates, a power awarded by voters.

John Cummings: The University of California had to raise its tuition by a total of 32% over the next two years from $7,788 to $10,302. This institution is not really dependent on California anymore with only 17% of its revenues coming from the state, which is a far cry from the 30% it represented years ago.

What is your outlook on state income taxes?

David Blair: Taxes are going higher in many states. California just raised income taxes temporarily with the intention of reversing the tax hike down the line but they'll probably extend it further because the fiscal problems won't be anywhere near over in the next year or two. The state is going to be forced to look at raising taxes, whether they are taxes on tobacco and alcohol, sales taxes or income taxes. Still, there is going to be resistance to tax hikes because of the two-thirds majority vote needed to pass new legislation. PIMCO is known for its secular outlook and macro calls on the economy.

How has this work helped municipal portfolios, especially those focused on California municipal bonds?

Bob Fields: PIMCO’s top-down, macroeconomic outlook and housing market research have kept us out of areas experiencing fiscal distress, including Riverside County, Imperial County and San Bernardino County. Another advantage is that PIMCO, due its sheer size, will get the first call on new issues and secondary trades. We also have access to top state finance officials such as State Treasurer Bill Lockyer.

In addition, our risk analytics system helps us keep diversified portfolios and avoid being heavily concentrated in any specific sector or type of bond. It’s important to remember, however, that diversification does not assure a profit or protect against loss.

We also sit on the trading desk so we see what's going on in the corporate and mortgage bond markets and emerging markets. The muni market tends to react to those markets, which helps us move nimbly in and out of positions. We have frequent interaction with other members of our investment community, which helps us vet ideas and share information.

What other advantages does PIMCO enjoy in managing municipal bond portfolios that differentiate it from its peers?

Bob Fields: Our competitors don’t have the opportunity to speak with Bill Gross and Mohamed El-Erian on a regular basis. Our economic forums and portfolio manager strategy meetings allow us to hear what other people think about the municipal bond market and discuss how it could impact other markets. That gives us a huge leg up and presses us to look at different perspectives.