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California GO Spreads Tighten; Analysts Cite High-Yield Action

SAN FRANCISCO — Spreads between what a California general obligation bond yields and the rate on a triple-A rated bond have narrowed sharply over the past two years, despite only small improvements in the state’s financial health.

State officials like to give some credit for the trend to a smoother budget process of late, but analysts say the tightened spreads mainly reflect the fact that investors have been aggressive buyers of high-yield paper, such as California’s, as interest rates have sunk in general and supply has been scarce.

Since early 2010, the spreads for states’ GO yields have contracted against Municipal Market Data’s generic triple-A municipal bond — from a high of 124 basis points for bonds maturing in five years and 163 basis points for 30-year debt, to 61 basis points and 101 basis points as of June 20, according to data from Thomson Reuters. A basis point is 1/100 of 1%.

California, typically the largest issuer in the country, has more than $80 billion of GO debt outstanding.

Investors have gobbled up the state’s bonds because they pay higher yields compared to other states.

One reason is that every state, with the exception of Illinois, has a higher rating than California.

“In the muni market, spreads these days don’t represent much at all,” said Matt Fabian, managing director of Municipal Market Advisors in Concord, Mass. “It is more a function of the overall yield environment rather than improving fundamentals in California.”

Municipal bond yield indexes over the past year have hit record lows amid less supply and low U.S. Treasury bond rates.

Fabian said investors saw California debt had some extra yield and a few institutional investors began buying the bonds more aggressively. The rest of the market followed.

“In reality, the risk of California defaulting is quite low,” Fabian said.

In California, according to its constitution, debt service payments are only second to schools in the order of payment guarantees.

But it is still the lowest-rated state by Standard & Poor’s and Fitch Ratings at A-minus. Moody’s Investors Service rates it A1, one notch higher than Illinois.

“You couldn’t tell that California is at the bottom of the barrel by the yields that the munis are generating,” said Marilyn Cohen, founder of Envision Capital Management in Los Angeles. “I have been doing this for 33 years and haven’t seen anything like it.”

The state’s finances, she said, which are still troubled, have had little to do with its yields.

“GO yields keep going on like nothing has happened,” Cohen said.

Rating analysts have taken favorable notice as Gov. Jerry Brown has worked to steer the budget away from one-time solutions.

Standard & Poor’s in February raised its outlook on the state to positive from stable, a move heralded by state officials as representative of California’s improving fiscal house.

Under Brown’s leadership, S&P said the budget has become more structurally balanced.

However, the agency has also warned the Legislature not to endanger the governor’s efforts.

“If lawmakers are unable to agree upon solutions to the state’s budget deficit that we view as credible, we may revise the outlook back to stable,” analyst Gabriel Petek said in a note in May.

Last week, lawmakers passed a $92.1 billion general fund spending plan that closed an estimated $15.7 billion shortfall. It was the second time in as many years that lawmakers passed an on-time budget.

The governor and his fellow Democratic lawmakers reached an agreement Thursday morning

The budget relies on Brown’s proposed temporary tax hike that will be put to voters in November to help raise most of the $5.9 billion of new revenue needed for the budget. If that fails, cuts will be targeted mainly on education.

Treasurer Bill Lockyer has said the budget passage means the state could go to the market to borrow money for short-term cash-flow needs.

One of the main reasons the budget process has appeared more tempered over the past two years is due to Proposition 25, which says that lawmakers will lose pay if they pass a late budget. It also reduces the threshold to pass the budget to a majority from a supermajority.

In 2009, California faced a cash crunch because of a late budget, which forced Controller John Chiang to issue IOUs instead of selling the usual annual issuance of revenue anticipation notes.

Cash flows remain a concern. Earlier in the year, Chiang had to find $3.3 billion to avert a cash shortage. Part of those measures taken included a $1 billion private placement of notes.

Since the 2009 budget problems, yields have slowly shrunk. The state’s five-year GO bond as of Tuesday had fallen to a yield of 1.40% from 2.55% two years earlier, the 10-year to 2.69% from 4.13%, the 20-year to 3.82% from 5.03%, and the 30-year to 4.18% from 5.28%, according to Thomson.

State officials believe the decline has something to do with better financial housekeeping.

“When you look at what the rating agencies have been saying and the spreads tightening, we believe that it is the market’s recognition of the progress that we have made fixing our fiscal house,” said  Lockyer spokesman Tom Dresslar.

California has sold more debt this year than last year, when it did much less bond issuance than usual.

The state has sold more than $3.2 billion of GO debt so far this year as it has doubled down on efforts to refund outstanding bonds while rates are so low.

The treasurer sold $1.9 billion of GO refunding bonds in March and $1.3 billion in April.

The refundings have saved the state hundreds of millions in debt service payments.

Brown has also scaled back on new-money debt sales since he took office while he has tried to get agencies to use money from previous bond sales that had been set aside.

California should be back in the market this summer with the sale of Rans, which would be used to finance the budget before tax receipts come in later in the year.

Last year, the state sold $5.4 billion of Rans in September after taking out a bridge loan earlier in the year in an effort to avoid potential market chaos caused by a stalemate in Congress over the country’s debt ceiling.

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