LOS ANGELES -- With a balanced budget and an upgraded credit rating, California is planning to price $764 million of general obligation bonds next week.
The deal includes $560 million that will go toward refinancing existing GO bonds and $205 million of new money that will be used to fund a variety of infrastructure projects.
The bonds will be sold Tuesday in a competitive offering, which the state believes will pencil out better for taxpayers in terms of cost, according to Tom Dresslar, a spokesman for state treasurer Bill Lockyer.
“The general rule of thumb that we currently operate under is for anything over $1 billion to $1.5 billion, typically it makes more sense to do a negotiated deal, depending on market conditions, of course,” Dresslar said.
In the past few years, most of California’s GO bonds have been sold in negotiated deals. Since 2007, only 3.8% of the total amount of GO bonds California issued were sold competitively, according to Thomson Reuters data.
The state last did a competitive GO bond sale in October, with a $540 million refunding. JPMorgan won the bid with a true interest cost of 3.2254%.
Next week’s new money bonds will have maturities in 2022, 2024 through 2027, and 2029. The refunding bonds will mature in 2014 through 2024, 2028, and 2030 through 2033.
Orrick, Herrington & Sutcliffe LLP is bond counsel and Public Resources Advisory Group is the financial advisor.
“We feel good about the credit,” said Craig Brothers, managing director of fixed income at Bel Air Investment Advisors. “It’s on sound footing and it’s trading stronger than it has in years.”
The Golden State’s credit quality began to stabilize in fiscal 2012 and has continued improving as its economy has strengthened and its approach to budget development has gotten better under Gov. Jerry Brown’s administration, according to Standard & Poor’s.
The credit ratings agency affirmed its A rating and a stable outlook ahead of next week’s deal.
“The stable outlook on all ratings reflects our view of the state’s credit quality in light of a stronger budgetary and cash position, both on a current and projected basis,” said Standard & Poor’s credit analyst Gabriel Petek.
Fitch Ratings also affirmed its A rating, after upgrading California from A-minus Aug. 5, and Moody’s Investors Service affirmed an A1 rating. Both gave stable outlooks.
Fitch said the upgrade was based on the institutional improvements made by the state in recent years, its disciplined approach to achieving structural balance in recent budgets, and the fiscal progress made by the state as it recovers from its severe budgetary and cash flow crisis of 2008-2009.
The market has also noticed these improvements, as indicated by the continued narrowing of credit spreads between California’s GO bond yields and the triple-A benchmark.
Since the beginning of 2013, spreads on the state’s GO yields have contracted against Municipal Market Data’s generic triple-A municipal bond. By Aug. 21, spreads on California’s five year bonds were down to 16 basis points from 35 basis points at the beginning of the year.
On ten year bonds, spreads came down to 53 basis points in August from 57 basis points at the beginning of the year.
Going back further to 2010, spreads have come down from 113 basis points in five year maturities and 146 basis points in ten year maturities.
“The improvement is due to the steadfastness exhibited by the governor and the legislature, and wisdom shown by the voters in passing the majority vote budget and tax increases,” Dresslar said.
These were Proposition 25, which eliminated the decades-long requirement that budgets must be passed by a two-thirds legislative majority—now they only need a simple majority—and Proposition 30, the measure to increase sales and income taxes to prevent cuts to the education budget.
A better national economy, state economy, stronger real estate market and jobs market, and higher underlying ratings are other factors contributing to the tighter credit spreads, according to Brothers.
“It’s a little wider in the ten years and beyond, but that’s because the curve is very steep and the strongest buying interest is in the first five years,” he said. “Then there’s a big move up in nominal yields from five to ten years, and there’s also a widening in spreads for every credit in that range relative to the first five years. So California’s no exception to that.”
Spreads in the 30 year maturities have narrowed by a smaller margin, at 62 basis points in August, compared to 155 basis points at the beginning of 2010. For 2013, spreads have actually widened slightly, from 57 basis points in January.
“They did do the fiscally responsible things and, therefore, we’re no longer thought of as the absolute worst state around,” said Marilyn Cohen, founder of Envision Capital Management in Los Angeles. “We’ve upped our profile. We’re no longer the ugly duckling sitting in the corner — that’s Illinois.”
Despite the improvements, Cohen doesn’t think they will have a significant impact on lowering the net interest cost on the new bonds.
“It probably won’t lower it tremendously, but maybe a smidge,” Cohen said. “California was so deeply at the bottom of the barrel for so long, I think investors want to see fiscal performance for more than just one year.”
Market conditions during the past few weeks make the timing for the deal less than ideal, Brothers said. For one, August tends to be a slower month when people are on vacation. Also, the market has been bombarded with bid lists from mutual funds that have had huge redemptions, pumping up supply in the secondary market, and causing primary deals to price cheaper.
“Although the state’s credit is stronger, and it’s trading narrower that it has for a long time, I think the timing of the deal in mid to late August is probably not the best,” Brothers said. “It really wouldn’t matter what credit you bring — it’s a function of the market conditions.”
These conditions could also make a competitive deal less cost-effective than a negotiated deal.
“On a competitive landscape, with the market feeling like it’s a little lopsided — there’s definitely a stronger selling interest than a buying interest — that might cause the bids that [underwriters] turn in to be cheaper,” Brothers said.
He plans on participating in the deal, saying he’s always been comfortable with the state’s ability to pay and the bondholder’s standing in the capital structure, even before the recent fiscal improvements.
According to California’s state constitution, GO debt service comes second only to state funding for public K-12 school systems and to institutions of higher education.
The state currently has more than $74 billion of GO bonds outstanding, and has already sold $5.1 billion of GO bonds this year. Last year, it sold $5.2 billion.
Earlier this month, the state sold $5.5 billion of revenue anticipation notes in its annual cash-flow borrowing. According to the state treasurer’s office, the deal priced at the lowest yields in a regular RAN sale since at least 1971.
The nine month maturities priced at 0.21% with a 2% coupon and the 10 month maturities priced at 0.23% with a 2% coupon. In 2012, similar maturities received 0.33% and 0.43% yields.
Throughout the past ten years, California’s debt burden has been on the rise and its various ratios are now all at moderately high levels, according to Standard & Poor’s. These ratios could remain moderately high, as California still has $36.5 billion in GO and lease revenue bond issuing authority.
“However, the state’s debt is structured conservatively, in our view, in that it has limited variable-rate exposure, and it has not entered into interest-rate swaps or other derivatives,” Standard & Poor’s said.
Analysts see potential for further upward rating movement if revenue performance meets budget assumptions and if the state can retire its budget liabilities in accordance with the Department of Finance’s forecast.