Buy Side

California Enjoys a Rebound

California’s general obligation bonds have caught fire since Moody’s Investors Service and Fitch Ratings slapped higher ratings on the state’s credit earlier this month.

The yield on the state’s 10-year GO debt has plunged 26 basis points since Moody’s announced it was recalibrating its ratings scale.

Whether the rally in the Golden State’s credit is because of the ratings recalibration or coincidentally after it is subject to debate.

The municipal market in general is on a hot streak, and some of the fiscal news coming out of California has been a bit brighter lately.

Still, the yield on California’s 10-year GO debt at the beginning of April was 139 basis points over the yield on the 10-year triple-A, according to Municipal Market Data.

Today, the spread is 106 basis points — representing 33 basis points of spread-tightening in a little more than three weeks.

The tightening comes after Fitch and Moody’s recalibrated their ratings scales to place state and local credits on a comparable scale with corporations and sovereign governments.

Under the ratings overhaul, California was bumped to A-minus from BBB by Fitch, and raised three notches to A1 by Moody’s. Is the recalibration fueling the rally in California paper?

“It isn’t hurting,” said Alex Anderson, who manages private accounts at Envision Capital Management in Los Angeles. “The less sophisticated investors would be more inclined to buy a California GO with an 'A’ on it. ... I’m sure that would make a big difference to them.”

Anderson pointed out that many investors in the retail-heavy municipal market rely on a bond’s rating because they do not conduct their own credit research.

A higher rating thus could spur buying even with no fundamental improvement in credit quality.

A trader in Los Angeles said institutional investors were buying California’s bonds in advance of the recalibration, anticipating retail investors would be more inclined to buy the state’s paper once it carried the higher rating.

The 10-year California GO spread over the triple-A peaked this year at 157 basis points in early March.

Moody’s announced it would recalibrate its ratings — in a way that signaled California’s rating would be lifted — on March 16. Fitch unveiled a similar announcement on March 25.

By the time Fitch began implementing the recalibration in early April, the spread had already tightened 20 basis points. Overall, the spread has tightened 42 basis points since the first Moody’s ­announcement.

“Going into it there was an expectation that it wouldn’t have an effect, but memories are short,” the Los Angeles trader said. “It certainly has gapped up here.”

A number of factors argue that the spreads could have tightened independent of the ratings adjustment.

Spreads on credit-default swaps on California’s five-year debt have tightened significantly since mid-March, according to Bloomberg LP. On March 15, it cost $243 a year to insure $10,000 in California debt for five years. Today, it costs $191 a year. That indicates CDS traders see less likelihood of California defaulting.

General fund revenue has exceeded budgeted estimates by nearly $2.6 billion the past four months, according to the state Controller John Chiang, including by $356 million in March.

Also, spreads in general have rallied. The triple-B rated 10-year municipal spread over the triple-A has compressed 12 basis points since mid-March. An example of a sector-spread tightening is single-A rated health care bonds versus the triple-A, which have narrowed 20 basis points.

While California’s spreads have tightened far more than that, quantifying the effect of the recalibration is a tricky task.

The majority of states were lofted into higher categories, so comparing other state’s spreads would not answer the question of whether changes there were caused by the adjustment.

In addition, a number of states, including Indiana and Tennessee, were newly minted Aaa under the Moody’s recalibration, and it is not clear whether that has affected the MMD benchmark yield.

Phil Condon, head of municipal portfolio management at DWS Investments, said California paper has exhibited unmistakable strength over the past few weeks, but he is not sure whether that is attributable to the recalibration.

More clients are putting money into higher-yielding bonds — including California — as risk appetites strengthen and people hunt for superior returns, Condon said. The spread-tightening may have more to do with the continuing supply shortage and heartier risk appetites than the recalibration, he said.

Condon said investors who do not routinely purchase municipal bonds would be the most likely influenced by the ­recalibrations.



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