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Short-Term Notes Indicate Improved State Finances

LOS ANGELES — The end of the fiscal year in California also marks the end of a more truncated, but important season for the state’s municipal bond issuers – tax and revenue anticipation note season.

Despite the sell-off that occurred in the municipal bond market during the final weeks of TRAN season, which begins in late May and ends in early July, issuers were still able to attain very competitive interest rates.

If TRANs are a refuge in tough times for municipalities experiencing cash-flow problems, then the drop in issuance volume for California issuers during this year’s notes season could be seen as an indicator of an improved fiscal picture for the state.

So-called TRAN season is a “traditional wave of the market,” said Robert Donahue, a managing director with Municipal Market Advisors.

“Every May through early July, as municipalities and states are adopting budgets, the issuers will go out with their notes during note season,” Donahue said. “Many of them are purchased by money market funds and held to maturity a year later.”

The states that have very big note seasons are California and New York, where the largest counties, certain cities, certain school districts, and community colleges sell notes to provide liquidity through the fiscal year in anticipation of state revenues, Donahue said.

The volume of California issuance dropped this year to $3.8 billion from $5.9 billion in 2011, according to data from Municipal Market Advisors.

Note issuers in the Golden State, which range from the billion-dollar-plus issuances of Los Angeles county and city, to smaller school districts and other municipalities selling a few million dollars, are getting better budget allocations from the state, which strengthens their cash flow positions, so they don’t need to borrow as much, Donahue said.

Property and sales tax revenues are also up for many California issuers, so they don’t need access to short-term debt in the way they did in previous years, Donahue said.

Total issuance nationally is only down slightly to $12.4 billion this year versus $12.6 billion, but some of that difference has been made up by an increase in issuance by New York, the second largest source of short-term notes, Donahue said.

New York’s issuance grew from $2.7 billion in 2011 to $3.4 billion this year, according to the MMA data.

“The improved state budget, strong market for short-term notes and improved credit quality has helped California issuers during TRANs season this year,” said Jeffrey Small, a managing director with Sacramento-based Capitol Public Finance Group.

He expects the decrease in the volume of TRAN issuance in California to continue, “in part because the state budget has improved.”

Credit analysts have dinged California issuers for having low reserves, which is why Small said his firm has seen a lot of public sector clients building reserves, so they are not as dependent on issuing short-term notes.

That has reduced the number of TRANs and the overall volume, Small said.

The recent sell-off in the municipal bond market had little impact on the ability of California issuers to sell tax and revenue anticipation notes during the traditional season for the short-term debt that typically runs from June through July.

“People like to buy them,” said Matt Fabian, an MMA managing director.

TRANs are an opportunity for funds to stretch the duration and get longer exposure than they do with seven-day floaters — and the yields are better, Fabian said.

“Notes provide an opportunity for tax-exempt money market funds to receive greater yield then they would from weekly, daily or commercial paper product,” Donahue said.

Notes provide stable supply that won’t be called away from them, he said.

Since a typical note matures anywhere from eight months to 300 days, the funds receive additional yield because it’s dollar-weighted average maturity, he said.

Money market funds can also extend their durations, because of the longer maturation of TRANs versus shorter-term debt, he said.

“Early on in the TRAN season, which begins the first week of June traditionally, rates were as low as we’ve seen them in any time during the last 25 years,” Small said.

“We had one issued by the Santa Clara Unified School District,” Small said. “That came in at 18 basis points.”

Even though Santa Clara is a great name, he said, it is a smaller issuer comparatively, and it was still trading at the same rate as some of the larger issuers.

It was a function of how great the demand was for short-term notes, Small, said adding that underwriting discounts are starting to shrink down to nothing, so investors were very aggressive.

“The week of June 20, when some of the turmoil started, TRAN rates seemed to back up a little bit, but still at rates that were exceptionally low as compared to prior years,” he said.

Improvements in the Golden State’s budget helped districts’ cash positions, he said, which has lessened the need for short-term notes and improved credit quality.

The passage of Proposition 30 in November 2012 raising state sales and income taxes has helped, Small said. The measure was estimated, prior to passage, to bring in an additional $6 billion annually to help K-12 schools, community colleges and state universities.

It allowed districts to avoid draconian cuts and helped them maintain and add to reserve levels, which makes it easier for districts to have adequate coverage, Small said.

It also reduced state deferrals. In years prior, the state has deferred scheduled payments to the school districts.

The decrease in state deferrals means school districts do not have to rely as much on short-term notes to even out cash-flow throughout the fiscal year, he said.

Natalie Brill, Los Angeles’ debt manager, said the city “did extremely well,” on the $1.3 billion note sale that priced last week.

The city averaged 16 to 18 basis points across the maturity dates from February 2014 through June 2014. Last year, the city achieved 21 basis points.

Brill attributed part of the sale’s success to improvements in the market, but also to very aggressive marketing that included a road show.

“We are seen as a good credit,” Brill said.

“We started seeing some economic growth over the last two years,” Brill said. “Property tax is stable. Sales tax is inching up; and at the end of the fiscal year, we did get a little additional revenue.”

The city was marketing $1.3 billion and had $6 billion in orders.

All of the large institutional investors came forward and bought, she said.

“One of the things investors look at is that we are a deep and diverse city,” Brill said. Los Angeles has a $7 billion general fund budget.

“Our biggest revenue is property tax and yet that only makes up 33% of our revenues,” she said.

While other revenues may have declined during the recession, Los Angeles never experienced a dip in property tax revenues.

Large cities and counties still have to issue notes to make up for what California budget wonks know as the “triple flip” which reduced local sales taxes and vehicle license fees and gave local governments instead more revenue from property taxes, which are billed and paid twice annually.

Los Angeles received the highest short-term ratings for its notes from the three largest rating agencies.

Investor concerns about the economic strength of both California and New York have abated, Donahue said.

“That has created a much better context under which buyers are more comfortable,” he said. “The credit issues and the ability to pay is stronger and that was reflected in the notes issues this year.”

A lot of the notes were trading close to the weekly index of SIFMA, which is a change over previous years.

“It reflects a flatter seven-day yield curve,” he said. “The funds are pressed to find yield. They were taking everything they could get during note season.”

The money market funds are starved for more supply. So much so, that investors would be willing to purchase self-liquidity bonds from credits as low as single-A rated.

“Many large investors believe that issuers would be well advised to issue floating rate debt with lines of credit on their own liquidity,” he said. “Issuers could find a great reception within the money market.”

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