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California GOs Tighten Amid Upgrade Speculation

SAN FRANCISCO — California’s general obligation bond yields have tightened against top-rated municipal debt since the November election, partly amid investor speculation that the state’s credit rating may be raised.

The yield spread between the state’s GOs and the benchmark Municipal Market Data’s triple-A bond index as of Monday had shrunk by 22 basis points for 30-year bonds, 15 basis points for 10-year bonds and two basis points for five-year bonds since the day before the Nov. 6 election, according to Thomson Reuters data.

“I think a lot of these spreads are tightening dramatically because the market is pricing in all the favorable news: Prop. 30 passing, the credit eventually getting upgraded, state credits being better than city, county, school district credits,” said Kenneth Naehu, head of fixed income at Bel Air Investment Advisors in Los Angeles.

“So the question a buyer has to ask themselves [is] are they buying on future good news or is that priced in?”

California is typically the largest issuer of municipal debt in the country each year with more than $80 billion of debt backed by the state’s general fund outstanding.

Matt Fabian, a managing director at the research firm Municipal Market Advisors, noted that the state’s general obligation spreads are “very tight” and don’t allow for much upside if the state’s credit is upgraded.

“It is better to be a seller than a buyer at that level, but reinvestment pressure is trumping normal valuation ideas,” Fabian said.

He said one of the reasons for the tightening is that falling yields in the market attracted more investors to California’s bonds.

The GO bonds are rated lowest of all state credits by Standard & Poor’s and Fitch Ratings at A-minus, and one notch ahead of Illinois at A1 by Moody’s Investors Service.

The narrowing of California yields against the benchmark index is a trend that began around two years ago as the state’s budget process began improving after years of turmoil and investors chasing higher yields found opportunity in California bonds.

As of Monday, five-year California GO bonds had closed a 50 basis point yield gap from a year earlier with the triple-A index.

The improvement in the state budget has drawn positive reactions from rating agencies, which downgraded state debt in 2008 and 2009.

Standard & Poor’s in February raised its outlook on the state to positive from stable after the release of Gov. Jerry Brown’s budget.

In June, Democratic governor signed 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 budget relied on the temporary tax hikes to raise $6 billion of new revenue. Voters signed off on that plan when they approved Proposition 30 earlier this month.

The state’s nonpartisan Legislative Analyst’s Office said in a report earlier this month that it expects California will face a $1.9 billion budget deficit for the next fiscal year, and could have a surplus by 2015.

One of the main reasons that the budget process appeared more tempered over the past two years is due to Proposition 25, which says that lawmakers must forfeit pay if they pass a late budget, and it reduced the threshold to pass the budget to a majority from a supermajority. The proposition was approved by voters on Nov. 2, 2010.

Investor faith in the state’s credit appeared at a low in 2009 when 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.

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