Even as California faces a $15.7 billion deficit that has grown almost 70 percent since January, the state spells opportunity for municipal-bond investors.

Debt of the world’s ninth-biggest economy is slumping the most in three months with a June 15 deadline for lawmakers to pass a balanced spending plan looming. The extra yield on California issuers relative to top-rated bonds rose as much as 16 percent in the past month, the steepest jump since March, Bloomberg Fair Value data show.

“I very often find myself attracted to situations where the noise is the loudest and the scariest,” Daniel Loughran, a portfolio manager with OppenheimerFunds Inc., said June 7 at the State & Municipal Finance Conference hosted by Bloomberg Link in Chicago. “Whether that’s Illinois or California, both states pay a borrowing penalty because of their situations.”

The budget strain, due in part to Governor Jerry Brown’s overestimate of tax revenue, may cost California an opportunity for a higher credit grade from Standard & Poor’s. S&P, which raised its outlook to positive in February, rates California A-, six grades below AAA and lower than any state.

The extra yield helped bonds from California earn 4.9 percent in the past six months, beating the 4.2 percent gain by the $3.7 trillion muni market, according to Barclays Capital indexes. The state still trailed eight counterparts in the period. It matched Illinois, which is rated two steps higher by S&P and faced $9 billion of unpaid bills as of March 31.

Taxes Trail

Brown, 74, announced May 14 that the deficit had grown from $9.3 billion in his January budget plan. The governor was counting on a gain in revenue that didn’t materialize, partly as a cooling economy depressed tax intake. Collections in April for the most-populous state were $2 billion below estimates.

Investors demanded as much as 0.95 percentage point of extra yield from California issuers this month, up from a three- year low of 0.82 points in mid-May, data compiled by Bloomberg show.

“During the budget process the noise gets louder and the spreads have widened out a little bit,” said Peter Hayes, a managing director at New York-based BlackRock Inc., which oversees about $105 billion of munis. “You can wait for that and buy or, if spreads tighten up once they pass the budget, you can sell. For most investors who really want the income, it remains a good long-term investment.”

Lawmaker Friction

When the state’s yield spread reaches about one percentage point, “I do think it’s a buying opportunity,” said Gary Pollack, who manages $12 billion as head of fixed-income trading at Deutsche Bank AG’s private wealth unit in New York.

California’s shortfall exceeds the total fiscal 2010 expenditures of more than a dozen states, including Utah and Kansas, according to data from the Henry J. Kaiser Family Foundation.

The wider gap has caused friction with Brown’s fellow Democrats in the Legislature, who have resisted his proposal to slice more than $2 billion from health and welfare. The lawmakers proposed an alternative that relies on a smaller rainy day reserve than Brown wanted and pares some cuts. The Democrats have been meeting to find a compromise, though they said they will pass their plan if no deal is reached.

Any budget holdups fostered by legislative conflict are a chance to add California debt, UBS AG said last month.

“For investors, we smell an opportunity,” UBS said in a May 11 report. “Budget delays are good fodder for adverse media coverage. For investors deploying cash, wider spreads may signal a good entry point.”

‘Dysfunctional Structure’

The state’s deficit is the result of a “dysfunctional” tax structure that hasn’t kept up with changes in California’s economy that have made it more dependent on services rather than retail sales, S&P said in a report this week.

“California’s consistent inability to balance its budget has, in our view, material credit implications,” Gabriel Petek, an S&P analyst, said in the report.

California has never defaulted on its securities, in part because it promises that debt service gets first call on general-fund money after education.

Investors see California as having a lower risk of default than some countries in Western Europe, including Belgium and Italy.

It costs the annual equivalent of about $253,000 to protect $10 million of California debt against default for 10 years, less than half the amount for Italy, data compiled by CMA show.

“Investors know the state’s debt is safe, it’s a yield chase,” California Treasurer Bill Lockyer said in an interview May 30. “They all know, and they hear it from their brokers, that they aren’t going to lose their money in this kind of investment. So they are looking for a little bit better yield.”

Tax Vote

The cornerstone of Brown’s plan is an initiative he’s pushing onto the November ballot to temporarily boost income taxes on top earners to the highest in the nation, and raise sales levies that now exceed rates for all states. Without the taxes, he said he’d cut $6 billion, mostly from schools.

He also wants to slice $1.2 billion from health care for the poor, $1.1 billion from welfare and assistance for the elderly and disabled and $500 million from courts. Brown is counting on reducing personnel costs by 5 percent, mainly by cutting workers’ hours.

California’s constitution permits legislators to pass a budget with a simple majority vote. Democrats control the Senate and the Assembly, though they don’t hold enough seats to pass a tax increase, which requires two-thirds approval.

A voter initiative passed in 2010 strips lawmakers of their pay for every day they’re late. Brown has until July 1 to enact the plan.