California rode a wave generated by two recent rating upgrades to draw close to a dozen bids on each tranche of a competitive deal to achieve true interest costs of 2.40% on a $1.14 billion taxable sale of general obligation bonds.
Fitch Ratings upgraded the state’s general obligation bonds in August to AA from AA-minus while Moody’s Investors Service elevated the GO rating to Aa2 from Aa3 on Monday. S&P rates the bonds AA-minus and hasn’t boosted the rating since 2015. All have stable outlooks.
“While many factors impact the pricing of the state’s bonds, we believe that the rating upgrades were a positive factor in achieving two bids with true interest costs less than 2.40%,” said Mark DeSio, a spokesman in the State Treasurer’s Office.
The deal that brought bids from 10 banks on the $457.4 million refunding tranche and 11 banks on the $680.1 million tranche is the largest taxable competitive deal done by the state, according to DeSio. The highest prior to this week’s sale was $842.9 million in taxables sold competitively on March 26.
“The treasurer told me that she is very pleased with the results of the competitive sale,” he said.
Morgan Stanley was the winning bidder on the refunding deal with a true interest cost of 2.39%.
Bank of America Securities outbid 10 other banks on the $680.1 million deal with a true interest cost of 2.359%.
Though the upgrades brought more bidders to the table, Matt Fabian, a partner at Municipal Market Analytics, questioned how much of an affect the upgrades had on price as California already prices rich to the Municipal Market Data triple-A curve.
“It’s less about the absolute level of the rating at AA or Aa2 versus momentum driving improvement at the state level,” Fabian said.
He added that the upgrades certainly don’t hurt.
“The thing about ratings is that even with Illinois, it’s never about the absolute rating level. You never assume a meaningful default risk on the part of the state. It’s always about momentum and whether the news about the state will trend better or worse affecting bond prices,” Fabian said.
The tranche won by Morgan Stanley refunds $300 million of outstanding variable rate GO bonds to reorganize the state's debt structure and current refunds $164.2 million of outstanding fixed rate GO bonds for debt service savings. The treasurer’s office estimated that the sale will save $1.7 billion on a present value basis.
Proceeds from the new money tranche won by B of A will provide $375 million of funding for the high-speed rail project, $60 million for the California Institute for Regenerative Medicine’s stem cell research and $245.13 million to take out commercial paper issued through 14 different bond acts that provide funds for schools, water, housing and stem cell research.
Public Resources Advisory Group is the financial advisor and Orrick Herrington & Sutcliffe is the bond counsel for both tranches.
The state expects to end the year with $19.2 billion in reserves, according to Gov. Gavin Newsom’s office. The state made an extra payment totaling $9 billion over the next four years to pay down unfunded pension liabilities.
“The state is prudently using a good portion of revenue growth to pay down long-term liabilities and maintain strong reserves, as required by Proposition 2, although we also remain concerned about increases in new Medicaid and housing program spending,” according to S&P Global Ratings analyst David Hitchcock, who co-wrote S&P’s ratings report with analyst Sussan Corson released Oct. 3.
The stable outlook reflects the state’s structural balance with recurring revenues sufficient to fund California’s legally required ongoing expenditure base at this high point in the economic cycle, according to the report.
Hitchcock and Corson had a long list of conditions before the state could see an S&P upgrade, though they did say it is a possibility.
“We attribute the state’s post-recession gains to a combination of cyclically favorable economic conditions, the previous governor’s emphasis on reserve accumulation, and California’s current tax policy,” Hitchcock said. “Should these long-term liability pay-downs significantly lower the state’s high pension and other-post employment benefit obligations, and fixed costs decline, so as to prepare the state’s historically cyclical finances for the next recession, we could potentially raise the raise or revise the outlook.”
California’s weakness is the volatility in revenues and reliance on capital gains, Fabian said.
“The state has done almost everything it can to mitigate that risk,” Fabian said. “They have paid down the budgetary debt, created systems to capture excess revenue and build reserves, and made a more resilient budget. They have done all the right things.”
The state’s economy also continues to grow rapidly and it is an increasingly massive issuer, Fabian said.
“If not for the volatility in revenues, they might already be triple A,” Fabian said.
Moody’s wasn’t concerned about recent talk that a recession could hit in the next two years as it upgraded the state.
“We expect our ratings to speak to the ability of any government, state or local, to be able to manage through, at a minimum, a moderate recession,” said Matt Butler, a Moody’s analyst. "There is also a lot of uncertainty as to when the next recession will be and how bad it will be."
California’s budget reserves and liquidity have never been stronger, he said.
“Revenues continue to grow and the state is using a portion of that to pay down debt and build reserves, rather than expanding spending up to that amount,” he said.
That the Legislature and Newsom, who took office in January, continue to build reserves helped Moody’s make its decision, Butler said.
“We have seen continued growth in revenue, economic expansion and a continued disciplined approach to the state's use of its funds,” Butler said. “In our minds, that supported the higher rating.”
Although California no longer has the fastest growing economy in the country, as it did a few years ago, Moody’s economists are still expecting growth to continue in the state, albeit at a more moderate pace, Butler said.
The state’s volatility, because of the tax structure’s dependence on income tax from high-income residents, holds it back from achieving a higher rating, Butler said. That and the state’s social problems including a high rate of poverty, and expansive support of the low-income population, which could present difficult spending decisions in a recession, he said.
“I think if you look at where California is with the upgrade to Aa2, it still falls below most states Moody's rates that land at an Aa1 or triple A,” Butler said. “While we did upgrade the state, we noted there are specific challenges the state faces, but also strengths. At Aa2 those strengths balance the challenges, even if the challenges persist.”
The state has $71.88 billion in outstanding debt as of Sept. 1, according to the treasurer's office. All three rating agencies considered that moderate given the size of the state's economy.
