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Brown's GO Revise Stretches Market

MAY 19, 2011 5:58pm ET
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SAN FRANCISCO — California Gov. Jerry Brown’s plan to cut bond sales as part of his new budget will stretch an already tight market for the state’s debt.

Despite its impact on the market, an analyst said the governor’s budget has a chance to lead to a better credit rating.

Brown released a revised budget Monday that dramatically reduces planned bond issuance as part of an effort to curb overall borrowing by the state that he termed the “wall of debt.”

The governor’s plan to trim general obligation bond sales will hit an already hamstrung California bond market still full of uncertainty caused by the long debate over how to balance the state budget.

“For sure, this is spread-tightening development,” said Matt Fabian, managing director for Municipal Market Advisors, a research firm specializing in municipal bonds.

Until a budget is in place, the state is unable to sell debt, and municipalities are also holding back because of unknowns about the budget’s potential impact on their bottom lines.

The lack of bond sales by California — the nation’s largest issuer of municipal debt — has caused an already shallow market to scramble for short-term debt.

“There is a growing realization across the market, not just in California but everywhere, that issuances are not going to be what people had hoped,” Fabian said.

Less issuance “will just add to that and it will underscore for California that people will need to find alternatives to the state,” he said.

California spreads between its general obligation bond yields and the triple-A GO curve for the previous three months averaged 86 basis points for five-year notes, 97 bp for 10-year paper and 104 bp for 20-year bonds as of Wednesday, according to Municipal Market Data.

Spreads — the difference between a bond yield and a risk-free bond yield — show how much demand exists in the market for a security.

A year earlier during a similar budget delay, the same spreads averaged 100 bp for the five-year notes, 131 bp for the 10-year paper and 144 bp for the 20-year bonds.

Fabian said it’s just a matter of time before a correction hits and short-term yields rise.

In the overall market Wednesday, the benchmark 10-year muni remained at 2.59%, its lowest since Nov. 9, 2010, and 68 basis points down from a recent peak on April 11.

The 10-year Treasury yield fell six basis points to 3.17%, while the 10-year muni-Treasury ratio, or spread, fell to a 12-month low of 81.70%, according to Thompson Reuters.

Brown’s revised budget proposal released Monday would cut California’s planned GO issuance in  fiscal 2012 by about 60% to $3.9 billion — $1.53 billion in the fall and $2.37 billion in the spring.

The GO sale would the state’s only new-money GO issue of calendar year 2011, after selling $10.5 billion of GOs in 2010. At the governor’s behest, the state has already skipped its usual springtime general obligation bond issue.

Brown’s budget plan presumes that the state can use existing unspent bond proceeds — around $11 billion — more efficiently.

California’s debt service is around 6% of general fund expenses, a little higher than the national average for states, according to Standard & Poor’s. However, debt service has been steadily growing in recent budgets.

Even though the market may suffer from one potential result of the budget, bondholders may benefit from another.

Gabriel Petek, Standard & Poor’s California analyst, said Brown’s budget approach is an improvement from a credit standpoint but the question is whether it is politically feasible.

“For the governor to propose a budget that is structural — in the sense that it is primarily reliant on reoccurring revenues or cuts — is something that could translate into improved credit quality in our opinion,” Petek said. “The problem with that is the implementation.”

Brown’s revised budget calls for $88.8 billion in general fund spending that would leave a $1.2 billion reserve at the close of fiscal 2012.

The new budget plan incorporates a $6.6 billion increase in the California Department of Finance’s revenue forecast for combined fiscal 2011 and fiscal 2012. Even with the new revenue, the deficit now stands at $9.6 billion.

Brown’s original budget in January, an effort to plug a $26 billion hole in the $86 billion general fund budget, mixed spending cuts with revenue from the tax extensions and from his plan to shutter redevelopment agency tax districts.

Most of Brown’s budget cuts have been approved. He has signed into law $11.2 billion worth of solutions to fill the gap, most of them spending cuts, out of $14 billion passed by the Legislature.

Like his first proposal, Brown’s revised budget assumes that lawmakers and voters will approve extending some temporary tax increases this year to close the remaining deficit, even though the governor was unable to persuade any  Republican lawmakers to agree to the original proposal he made in January.

Brown, a Democrat, needs a handful of Republican votes to get the two-thirds majority needed to call a special election.

On Monday, Brown confirmed that he is still talking to a handful of GOP lawmakers in an effort to put the tax extensions on the  ballot, likely in the fall.

He also said he continues to support a plan to shutter the state’s redevelopment agencies, another proposal that floundered earlier this year because Republican opposition denied him the necessary two-thirds votes in the Legislature.

“The May Revise goes too far on taxes and not far enough on reforms,” Senate GOP leader Bob Dutton said in a statement following the release of the governor’s new budget on Monday.

Last week, Assembly Republicans released their own spending proposal they say would balance the budget primarily with cuts, but without any of Brown’s tax extensions.

If the budget stalemate takes too long, the state again may be forced to take aggressive actions to shore up cash to pay for operations, including possibly issuing IOUs.

That, Petek said, is a major concern.

“I think the near-term pressure on the state’s credit rating has to do with the cash situation,” the analyst said.

Treasurer Bill Lockyer has said the state must have a balanced budget in place before it can issue short-term revenue anticipation notes, which puts pressure on lawmakers to reach an agreement that has the  confidence of the market.

Every year California sells notes to help pay for operations in the front end of the fiscal year because tax revenues are stronger in the second half.

In 2009, Controller John Chiang issued IOUs after the state was unable to reach a budget agreement in time to go forward with its annual $10 billion revenue anticipation note sale.

Chiang also took other cash management actions before giving IOUs to creditors with lower legal standing, in order to preserve cash to those with higher standing, such as bondholders.

Ana Matosantos, head of the Finance Department, has said the state still plans its annual sale of around $10 billion of Rans, usually slated for the summer.

But Lockyer said in a statement that his office would be unable to issue the notes if the budget is contingent on voter-approved taxes, unless it included cuts that could be quickly put in place if voters reject the tax extensions.

California GO bonds carry ratings of A1 from Moody’s Investors Service and A-minus from Standard & Poor’s and Fitch Ratings.

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