SAN FRANCISCO — Moody’s Investors Service and Fitch Ratings yesterday said they planned to upgrade California’s economic recovery bonds after a $3 billion refunding deal next week.

The upgrade, to A1 from Baa1, applies to the refunding bonds and would also apply to another $5.2 billion of outstanding ERBs “when this transaction has closed,” Moody’s said.

The short-term rating on the Series 2004C-1 through C-5 will be upgraded to VMIG 1 from VMIG 3, according to the agency.

Fitch late yesterday raised the rating on the ERBs that are being refunded to an A and places the outstanding parity ERBs on rating watch positive. “Upon closing, anticipated on Nov. 5, Fitch expects to upgrade them to A from BBB based on the restructuring of debt service as a result of the refunding,” the agency wrote.

California’s general obligation bond rating remains at Baa1 from Moody’s and BBB from Fitch, the lowest for a U.S. state.

California garnered a higher rating for the ERBs because the refunding will restructure the debt to increase debt-service coverage ratios. The bonds, which currently have a front-loaded maturity schedule, will mature with level debt service between now and 2023 under the refunding plan.

“The A1 rating is a reflection of the increased coverage of debt service provided by the refunding structure,” Moody’s analyst Emily Raimes said in a report. “This makes the credit’s reliance on the state’s general obligation guarantee much less likely and allows the credit to once again 'pierce the GO ceiling.’ ”

The ERBs, first issued in 2004 to resolve the state’s previous major budget crisis, are backed by a dedicated quarter-cent sales tax and California’s GO pledge.

The double-barreled structure allowed them to garner higher ratings than the state GOs until this year. The bonds were downgraded by all three major rating agencies in the wake of a 10.9% drop in sales tax collections in fiscal 2009 and a lowering of the GO rating.

Standard & Poor’s lowered the economic recovery bonds to A from A-plus in July. The agency had not yet released ratings on the refunding at press time yesterday.

The refunding deal, which is expected to price Oct. 29, will revamp the term structure of the ERBs to provide at least 1.3-times debt service coverage based on “very conservative” estimates of future sales tax collections, Moody’s said.

The estimate assumes another 11% drop in sales taxes in fiscal 2010 and no growth thereafter. Under a “hard-landing” scenario that assumes a 15% drop in revenue in 2010 and another 10% drop in 2011, the debt service coverage ratio would remain above 1.1 times.

Given a 31% drop in 2010 tax collections and no growth thereafter, the sales tax would still fully cover the debt service payments.

“Given that revenues fell significantly in 2009 and that national economic signs are beginning to show signs of stabilization, all these scenarios are deemed to be very conservative,” Raimes said.

Taxable sales in California increased at an average annual growth rate of 3.3% over the past 20 years, she said.

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