Los Angeles Bonds: Navigating Fiscal Crossroads Amid Public Safety Reallocation Risks

The City of Los Angeles faces a fiscal reckoning as it balances budget cuts to public safety and homelessness programs against rising borrowing costs and credit downgrades. For municipal bond investors, the situation presents a high-risk, high-reward scenario: a city grappling with structural deficits and safety trade-offs, yet offering widening credit spreads that could reward those who bet on its ability to stabilize.

Fiscal Sustainability Under Pressure

Los Angeles' $14 billion 2025-26 budget reflects a stark reality. To avoid 1,000 layoffs, Mayor Karen Bass's administration slashed police recruitment (from 480 to 240 officers) and fire department hiring (227 to 58 new hires), while reducing homelessness spending by 10%. These cuts aim to close a $970 million deficit, but they've drawn fire from council members who argue that underfunding safety and housing exacerbates long-term risks.

The city's structural deficit—exacerbated by rising labor costs, litigation liabilities, and wildfire-related expenses—has already triggered credit downgrades. S&P Global Ratings lowered Los Angeles' general obligation (GO) bonds to AA- from AA, citing reserve fund depletion (now at 3.22% of the general fund, below the mandated 5%) and a “structural imbalance” that could worsen through 2028. KBRA similarly downgraded MICLA lease revenue bonds to AA-, with a negative outlook.

Public Safety Reallocation: A Double-Edged Sword

The budget's focus on reducing public safety spending raises critical questions: Can Los Angeles maintain safety with fewer officers and firefighters? Critics warn that reduced police presence (projected to drop to 8,400 officers by 2026 from 10,000 in 2020) and delayed wildfire recovery investments (e.g., fewer fire trucks and helicopters) could heighten operational risks. Meanwhile, the controversial “Inside Safe” homelessness program—costing $7,000/month per individual—has drawn scrutiny for inefficiency, even as funds are shifted to a new oversight bureau.

For bondholders, these trade-offs translate to tangible risks. Lower reserves and rising liabilities could strain cash flows, while litigation over the January 2025 wildfires (including potential inverse condemnation claims) adds uncertainty. Moody's and Fitch have already flagged Los Angeles' GO bonds with negative outlooks, signaling that further downgrades loom if reforms falter.

Credit Spreads: A Buying Opportunity for the Bold

Despite the gloom, there's a silver lining for cautious investors. Los Angeles' municipal bonds now trade at wider credit spreads compared to safer benchmarks, offering a potential margin of safety. For instance, the city's GO bonds currently yield 4.2%—a 0.7% premium over California's AA-rated municipal bond index.

This spread widening reflects market skepticism about Los Angeles' fiscal path. However, the city's moves to restore 150 civilian LAPD positions, avoid mass layoffs (now reduced to ~700), and redirect funds to infrastructure (streetlights, cultural programs) suggest a partial rebound is possible. If the city can stabilize reserves, control litigation costs, and secure state aid, credit ratings could stabilize—or even improve—by late 2026.

The Investment Thesis: Timing the Turnaround

Los Angeles bonds are a bet on fiscal discipline and structural reforms. The key risks—ongoing wildfires, litigation, and labor contract rigidity—are significant, but so are the potential rewards. Investors who buy now could profit if:
1. Reserves rebound: The city restores its general fund reserves to the 5% threshold by 2027.
2. Litigation costs cap: Settlements from wildfire claims don't exceed budgeted provisions.
3. State/federal aid materializes: Governor Newsom or Congress provides relief for homelessness or infrastructure.

For a conservative strategy, focus on shorter-dated bonds (e.g., tax anticipation notes rated MIG 1) or water system revenue bonds (rated AA- by Fitch), which benefit from stable utility cash flows. Avoid subordinate wastewater bonds with negative outlooks unless yields exceed 5%.

Final Call: Proceed with Caution, but Proceed

Los Angeles' fiscal challenges are undeniable, but its bonds now offer a rare entry point for investors willing to stomach volatility. The city's structural reforms, if successful, could narrow credit spreads and stabilize ratings. For those with a long-term horizon and a tolerance for risk, Los Angeles municipal debt in 2025 is a contrarian play—one that may pay off as the city rebuilds its financial footing.

Act now, but diversify. Los Angeles isn't a sure bet—yet.