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With Spreads Tightening, Investors Move Up in Credit Quality

State credit spreads have compressed across the curve over the last few years as investors move down in credit quality to pick up extra yield. With lower-rated credits compressing and now trading on top of higher-rated credits, many market participants think now is the time to exit those trades before spreads start widening.

Market participants say that by moving back into double-A rated credits from single-A rated ones, the investor isn't losing any income, and is moving up in credit quality.

"Some states that held ground when credit concerns were very high are now competitive alternatives to those that have performed extremely well since the lows," said Robert Vogel, head of municipal bond pricing at Markit. "The landscape is very different now and opportunities to improve risk-return portfolio profiles have come back into play."

California is the prime example. Over the course of two years, the single-A rated credit is now trading about where double-A credits are trading. The Golden State is rated A1 by Moody's Investors Service, A by Standard & Poor's and A-minus by Fitch Ratings.

From March 2011 to March 2013, the five-year state GO spread compressed 155 basis points to 1.08% from 2.63%, according to the Municipal Market Data scale. The 10-year MMD yield tightened 175 basis points to 2.43% from 4.18%. The 30-year yield came in a whopping 206 basis points, to 3.78% from 5.84%.

According to data from Markit, California 10-year GOs compressed to 51 basis points above their internal triple-A scale in March 2013 from 130 basis points in March 2011.

"California has compressed," said Adam Mackey, head of muni fixed income at PNC Capital Advisors. "Firstly, California has done a lot of things right on the credit side relative to two years ago. And there has also been an increase in demand for California paper in a time where there have not been as many California bond issues."

He said relative to the triple-A scale, 10-year California state GO paper was trading 190 basis points over about two years ago, and compressed 160 basis points to trading 30 over the triple-A scale. "Really anything single-A or triple-B rated has compressed dramatically as investors reach for yield," Mackey said.

Single-A rated paper has compressed at a much faster rate than double-A state GO paper, leading many to think single-A paper no longer provides attractive risk-adjusted return — especially when buyers can buy a double-A rated state GO for about the same price. If investors trade out from lower-rated credits in higher-rated state GOs, California could come out the big loser.

"We think California has all the good news priced in it," one Pennsylvania trader said. "Everything has to go right for California to justify these valuations. And once that trade happens out of California into double-A credits, spreads will widen." The trader said spreads could widen 25 basis points based on market technicals.

Others agree the good news in California is priced in and is even trading as a double-A rated credit.

"California is more an anomaly," said Eric Friedland, head of municipal research at Schroders Investment Management. "Credit spreads across the board haven't come in uniformly, but California has tremendously."

He added that California was trading at a wide spread, but credit news has been positive for the state. At these levels, an upgrade is priced in. "Investors are waiting for news of an upgrade, which is forcing spreads tighter than where they should be. It's being treated as a double-A state," Friedland said.

Still, others think California still has room to outperform.

"For total-return players that aren't completely focused on yield, I think California still makes sense because it is likely to outperform many other states," said Burt Mulford, portfolio manager and trader at Eagle Asset Management. "You're giving up yield because of the recent demand, but from a price-return perspective, I think California has some upside potential."

He noted that investors are becoming more comfortable with California GOs. "There is a positive outlook by Fitch while S&P recently upgraded the credit," Mulford said. "There are still pockets of weakness, but investors are realizing that California is not going to default. It's more likely to get upgraded than downgraded."

Indeed, an upgrade to a double-A rated credit may be priced in already. "There has been significant spread compression across the board where you see double-A states trading at plus 10 or 15 basis points," Mulford said. "California still looks cheap if you can buy at plus 35 basis points. But the positive trends in the credit are already priced in."

To be sure, double-A rated paper has compressed, though not as much as single-A credits. "Michigan, Ohio, New Jersey and Nevada have all compressed too," Mackey said. "Everything has compressed as interest rates have gone lower and all of most double-A GOs are trading on top of each other."

Others agree certain double-A rated credits look attractive. "Spread compression on states that had traded weaker than other double-A paper have come in quite a bit, including Nevada, Michigan, New Jersey and Arizona," Markit's Vogel said. "Looking at the data, it seems that some double-A states — like Massachusetts, New York, Pennsylvania and Wisconsin — offer similar yields with stronger perceived credit profiles."

New Jersey, rated Aa3 by Moody's and AA-minus by Standard & Poor's and Fitch, trades tighter than some of the solid double-A rated credits. The five-year MMD yield fell 143 basis points to 1.07% in March 2013 from 2.50% in March 2011. The 10-year yield fell 175 basis points to 2.22% from 3.97% and the 30-year yield came in 186 basis points to 3.44% from 5.30%.

New Jersey trades 33 basis points over Markit's internal scale, down from 40 basis points over in March 2011.

Nevada, rated Aa2 by Moody's, AA by S&P and AA-plus by Fitch, is trading almost on top of California. The five-year yield compressed 144 basis points to 1.03% in March 2013 from 2.47% in March 2011. The 10-year yield tightened 165 basis points to 2.34% from 3.99% and the 30-year yield declined 196 basis points to 3.54% from 5.50%.

As of March 2013, Nevada traded at 45 basis points over Markit's internal triple-A scale, just six basis points away from where California trades at 51 basis points. Nevada compressed from 75 basis points above the scale in March 2011.

Spreads on double-A rated Rhode Island GOs have compressed, though not as much as single-A rated states. The five-year yield tightened 107 basis points to 1.13% in March 2013 from 2.20% in March 2011. The 10-year came in 145 basis points to 2.29% from 3.74%. The 30-year yield compressed 171 basis points to 3.54% from 5.25%.

Spreads on Rhode Island GOs compressed to 40 basis points over Markit's internal triple-A scale in March 2013 from 55 in March 2011. Rhode Island trades 11 basis points tighter to Markit's internal scale than California.

Michigan — rated Aa2 by Moody's, AA-minus by S&P and upgraded recently by Fitch to AA — has tightened, though many think there is still room for outperformance.

The five-year MMD yield compressed 142 basis points to 1.03% in March 2013 from 2.45% in March 2011. The 10-year yield tightened 175 basis points to 2.24% from 3.99% and the 30-year yield came in 216 basis points to 3.44% from 5.60%.

Michigan trades 35 basis points off Markit's internal benchmark scale, 16 basis points tighter than were California trades. It has compressed from 85 basis points in March 2011.

Connecticut GOs show the same story. The five-year yield compressed 100 basis points to 0.99% in March 2013 from 1.99% in March 2011. The 10-year yield tightened 125 basis points to 2.18% from 3.43%. The 30-year yield came in 161 basis points to 3.36% from 4.97%. The bonds are rated A1 by Moody's and AA by Standard & Poor's and Fitch.

In a reverse of the trend, spreads on Connecticut GOs have widened to 30 basis points above Markit's internal benchmark scale in March 2013 from 28 in March 2011.

Not all single-A credits are created equal and Illinois has not compressed as much as California. The five-year yield came in 187 basis points to 2.00% from 3.87%, while the 10-year yield tightened 163 basis points to 3.47% from 5.10%. The 30-year yield came in 194 basis points to 4.36% from 6.30%. The state is rated A2 by Moody's, A-minus by S&P and A by Fitch.

In March 2013, Illinois traded 151 basis points above Markit's internal triple-A benchmark scale, down from 215 basis points in March 2011.

One trade investors say makes sense is swapping California GOs for Illinois GOs. Friedland says the strategy makes sense to pick up extra yield — especially for those investors who believe California spreads have reached their tights while the Illinois spreads have gapped.

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