LOS ANGELES -- A new Sanford C. Bernstein & Co. report recommends treating local credits in California with caution, saying that their long-term prospects "are less healthy" than those of the state itself.

The report is especially concerned about California counties, concluding that many of their ratings are too high.

"The current municipal story in California, in essence, is being played out at two separate levels: state and local," says the report, which was prepared by Joseph Rosenblum and Fred Cohen.

Sanford Bernstein continues to believe that the double-A rating on the state's general obligation bonds, the level assigned by Moody's Investors Service and Fitch Investors Service, is justified.

Standard & Poor's Corp. rates the state GO bonds A-plus.

A double-A assessment is also "higher than the A or A-plus implied by where California bonds have been trading," the report notes. "In essence, the bond market has overreacted to California's problems."

Yields higher than those consistent with a double-A rating on the state GOs "continue to represent an attractive opportunity," the report says.

But the story is less positive at the local level. State changes in local government resources have produced a cumulative net impact of $2.4 billion in local funding losses from fiscal 1992 to 1994, according to Sanford Bernstein's calculations.

The concern is heightened for counties because they "have been the most negatively affected by the state's current economic and budget woes."

The recent passage of Proposition 172, which extends a statewide half-cent sales tax increase for local purposes, only replaces part of the revenues lost by counties because of recent state tax shifts of property tax revenues, the report notes.

Nor does the sales tax "address the more basic issues challenging inter-governmental relations in the state today -- namely, the issues that revolve around the proper level of government support, the appropriate assignment of program responsibility, and perhaps most important, who should be held accountable for programs," the report says.

Given the differing outlook for various types of government, the Sanford Bernstein report concludes "it is surprising that there is very little yield difference among the many issuers' municipal bonds in the California market."

For example, yields on San Francisco lease obligations recently were only 35 basis points higher than those on California Department of Water Resources revenue bonds, according to the report.

This is "a rather narrow, margin when measured against historical standards," the report says.

Accordingly, Sanford Bernstein views this situation "as an opportunity to construct portfolios with relatively high expected returns that are both exempt from state taxes and well insulated from the state's economic woes and the developing problems of local authorities."

Using that criteria, "a diversified set of California pre-refunded and insured bonds should compose a large portion of a California portfolio today," the report recommends.

To the extent they can be purchased inexpensively, "essential purpose revenue bonds -- such as those backed by water, sewer, or electric system revenues -- offer credit stability and should constitute the remainder of the portfolio," the report says.

The 17-page report, an update on previous California reports by the firm, also discusses short- and long-term economic outlooks for the state, as well as issues such as the North American Free Trade Agreement and illegal immigrants.

Regarding the state's economy, "some signs suggest a trough may be at hand," Sanford Bernstein says. "But no real turnaround is in sight; it will probably be another year before recovery begins in earnest." The rebound will be muted by factors such as an overbuilt commercial real-estate sector and declining defense spending, the report says.

"In the long run, however, California's economy will resume its strong growth," the report says, citing a well-diversified economy, strategic trading position, increasing population, and existing wealth.

But a defensive investment strategy toward local issuers may be appropriate because they are "weaker credits than they used to be," the report says.

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