LOS ANGELES — The average fee that bankers were paid to underwrite municipal bond deals in California reached a record low last year, as firms faced stiff competition to get deals done in the Golden State.
On average, state and local governments paid underwriters $3.98 per $1,000 of bonds sold in California during 2013 — the lowest average fee on record, according to Thomson Reuters data, which goes back to 1980.
"It boils down to a couple of things," said Peter Stare, senior vice president at FirstSouthwest. "First of all, California is an extremely competitive market on the underwriting side, and to be competitive out there, you have to work for thinner spreads."
He said another factor is that deals in California are typically larger than the average deal, nationwide.
"There are so many large issuers there," Stare said. "And larger deals basically get tighter spreads because the overall dollars are greater."
Among the 11 largest general-purpose deals in 2013, six were from California issuers, including four multi-billion dollar deals from the state of California and a $1.3 billion deal from Los Angeles.
Overall, issuers in California sold $49 billion of debt in 824 issues last year — more than any other state.
"California is a very desirable market to be in," said Christopher Mier, chief strategist and director of the analytical services division at Loop Capital Markets. "To be considered a national underwriter, firms must have a presence in California."
Loop Capital Markets was ranked 14th among underwriters in California in 2013, with 14 deals completed worth $680 million.
Mier said the state offers a wide variety of issuance and a large investor base, including mutual fund companies and individual bond investors.
"This wide range of desirable elements makes it attractive to all types of firms," he said. "As a result, there's a large number of firms with California presence, and great competition for senior manager role on deals, which drives down underwriting spreads."
The average spread on California deals has come down more than 29% since 2009 when it peaked at $5.62.
During that time, deals were riskier to underwrite and fewer banks were competing for business following the financial downturn.
"There are very few deals to go around right now and that's the big picture perspective," an underwriter in California said. "I'm seeing hiring on the desks and new people in Los Angeles and San Francisco — those shops are growing their desks and they need to keep as much business as possible, so everybody's looking to get as much quantity through to bring up the dollar amount on the year."
The decline in spreads hasn't been just on California deals — they have been falling across the nation since 2009. The average national spread has come down nearly 20% since 2009, when it peaked at $6.11.
In 2013, the average spread across all states was $4.91.
The decline is steeper in California, however, where spreads have tracked significantly lower than the nationwide average for the past seven years.
In 2007 California's average underwriting fee was 41 basis points lower than the national average. It was 79 basis points lower in 2010, and 93 basis points lower last year.
"California's had some increase in perceived value and demand, brought on by a couple of components," said David Manges, a managing director and municipal trading manager at BNY Mellon Capital Markets. "One is a perceived improvement in the credit at the state level, and I think that has made any number of buyers more confident in positioning and buying any number of California bonds, but particularly state GOs."
California's credit quality began to stabilize in fiscal 2012 and has continued improving as its economy has strengthened and it has taken a more structural approach to budget development under Gov. Jerry Brown's administration, Standard & Poor's said in a March report.
The agency upgraded the state's rating from A-minus to A in January 2013, and revised the outlook from stable to positive at the beginning of this year, saying it could further upgrade the rating in the next two years.
Standard & Poor's has said the state is on track to finish the year in the strongest fiscal position of the past decade.
Fitch Ratings upgraded the state's rating to A from A-minus last August and assigned a stable outlook. The upgrade was based on institutional improvement and fiscal progress the state made following its budgetary and cash flow crisis in 2008 to 2009.
Moody's Investors Service rates the state A1, with a stable outlook.
Higher state taxes have also contributed to an increase in perceived value of California bonds, according to Manges.
"The tax increase that was put through last year would make California tax-exempt bonds more attractive — certainly to the in-state investors," he said.
Proposition 30, approved by voters in November 2012, increased personal income tax on residents with an annual income over $250,000 and increased the state sales tax by 25 cents.
California's top marginal tax rate is 13.3% for taxable income above $1 million.
"I really do think it's competition," said Sara Brown, managing director at Stifel, Nicolaus & Co. "California is a state that enjoys a pretty vast group of financial advisors that work with cities and they are pretty good about moving business around and making it a competitive process. "
In general, she said most cities and school districts go through a request for proposal process to select an underwriter.
"It's hard for a staff person who's going to be second-guessed by their governing body to explain why they chose one underwriter versus another one," Brown said. "You have two arguments: who's the better suited one, and who has a lower fee. In a niche space, you see higher average takedowns, while in a general space like utilities — there are many players in that arena."
In other states, issuers may be less interested in using the underwriting spread as the way to select a firm, according to an underwriter on the West Coast.
"I think, for example, if you have an underwriter acting as financial advisor, they are less focused on the fee and more focused on the other things that the underwriter could bring to the table," he said.
He added that in California, there aren't a lot of underwriters acting as financial advisors.
Los Angeles is trying to be even more restrictive; it recently put out RFPs seeking financial advisors, which included language that excluded firms "that underwrite or otherwise trade in municipal bonds."
The city later made the wording more stringent, revising it to preclude prospective financial advisors from underwriting or purchasing bonds throughout California during the term of the contract.
"There are a lot of FAs in California, and you don't see a lot of underwriting companies going across the fence to act as FA," the underwriter in California said.
Compared with other states, California had the fifth lowest average underwriting spread last year. New Jersey had the lowest spread at $3.00, followed by Alaska at $3.20, Nevada at $3.24, and North Carolina at $3.93, according to Thomson Reuters.
Iowa had the highest average spread at $11.22, followed by North Dakota at $9.73, and Nebraska at $8.83.
"All things being equal, I think you have decent demand and limited supply, and that plays out to some extent in the yields, but it also plays out in the underwriting spreads," BNY Mellon's Manges said. "With fewer deals, you have no fewer underwriters competing for them. So that competition should drive spreads down all by itself."
Overall municipal bond supply has remained muted for the past few years, declining by 12.5% from the year before to $335 billion in 2013.
In California alone, issuance was up by 15.4% from 2012 at $49 billion, but was still weak compared to years prior, when annual issuance came in at well above $50 billion each year.
"I think that this type of thing is going to be cyclical and will very much be supply and demand-dependent," Manges said. "A large increase in supply, for example would probably move those spreads back out. But tight supply would pressure on them to remain low."
Oliver Renick contributed to this story.