California could be canary in the coal mine for municipal bonds

Bond rating company Moody's (MCO) has downgraded the State of California's general obligation (known as "GO") bonds to Baa1, from a level of A2. The new rating is three notches above "junk" status. Moody's expressed concern that the ongoing political gridlock stemming from a $26 billion budget deficit will continue, and could eventually lead to certain debt service payments being put at-risk. California also remains on the watchlist for potential further downgrades; as a borrower's credit rating falls, it becomes more difficult and expensive to obtain additional financing.

The cash crisis in the state, which has been hit hard by the collapse of the housing market, has led to certain groups receiving "IOUs" in lieu of actual payments. Several major banks temporarily accepted such IOUs, but their originally annouced deadline windows have since passed. Speculation about California's creditworthiness, both as it relates to GO bonds and IOUs, has created some market interest at trying to buy notes at a discount.