"MTAM expects that this upcoming deal will need to cheapen up relative to where the secondary market spreads have been as of late," said Michael Pietronico, chief executive officer and senior portfolio manager at Miller Tabak Asset Management.


With its credit reputation on the upswing, California was in a position to capitalize on Thursday when it priced $1.2 billion of general obligation bonds.

The Nov. 13 competitive offerings were sold in three series of taxable, tax-exempt and refunding bonds.

The $630 million portion of tax-exempt bonds, with a final maturity in 2044, was won by BofA Merrill Lynch, with a true interest cost of 2.949, according to preliminary numbers from Thomson Reuters.

The portion included 10-year maturities that priced at 2.40% with a 5% coupon-23 basis points above the benchmark municipal debt, according to Municipal Market Data.

That compares with a September GO bond deal, in which 10-year bonds priced at 2.48% with a 5% coupon and a spread of 27 basis points above the benchmark.

The $304.3 million refunding portion was won by Morgan Stanley, with a true interest cost of 3.799%. Citigroup won the $270 million taxable portion with a 0.9560% true interest cost.

The state's credit quality has improved significantly in the past two years, most recently boosted by an upgrade to A-plus from by Standard & Poor's on Nov. 4. The upgrade came after California voters approved a rainy day fund ballot measure.

The agency said the constitutional provision would partially mitigate California's volatile revenue structure by setting aside windfall revenue for use during periods when state tax revenue could fall materially short of forecast.

"We expect that California will now build a material budget stabilization account fund balance in the coming years, and that it will continue to pay down deferred liabilities and debt in advance of the 2018 expiration of a temporary income tax surcharge," said Michael Pietronico, chief executive officer and senior portfolio manager at Miller Tabak Asset Management.

He also said the state's financial position at the end of fiscal 2014 was its strongest of the past decade.

Pietronico predicted that the state's GO bonds would need to cheapen up relative to where the secondary market spreads have been, as overall market supply has been elevated lately and direct demand has been inconsistent due to overall low yields and a surging stock market.

Moody's Investors Service, which upgraded the state's rating to Aa3 from A1 in June, said the passage of the rainy day fund measure is a credit positive for the state. The agency affirmed its Aa3 rating on the bonds.

Rob Williams, director of income planning for the Schwab Center for Financial Research, said the upgrade is a positive in some ways, but a negative for investors that are looking for a boost in yields.

"The average individual retail investor is really still looking for yields," he said. "It may be surprising, but the higher credit quality is not what they're looking for."

Williams added that institutional buyers are still looking for supply and a big deal in California is appealing to them, but they're also looking for yield and an upgraded credit is not as attractive.

He said he expects demand from institutional buyers to continue, given the lack of supply in the market.

"They're getting less in return for it, just given what the absolute levels are," Williams said.

Thursday's deal included $304 million series of tax-exempt refunding bonds that will advance refund outstanding GO bonds for debt service savings. The state estimates the present value savings to be about $40 million, according to Drew Mendelson, spokesman for State Treasurer Bill Lockyer.

The largest series -- $630 million of new money tax-exempt bonds -- will fund projects from 12 different voter-approved bond acts. The largest amount-$580 million-is for transportation projects under Proposition 1B, the Highway Safety, Traffic Reduction, Air Quality, and Port Security Bond Act of 2006.

"The state's general obligation bond law requires that the bonds be sold on a competitive basis unless the treasurer determines that a negotiated sale will result in a lower interest cost," Mendelson said. "For this sale, we do not believe a negotiated sale would result in a lower interest cost, therefore we are selling the bonds on a competitive basis."

Orrick, Herrington & Sutcliffe LLP is bond counsel. Public Resources Advisory Group is financial advisor.

As California's financial position has improved in past years, its GO bond yields have contracted against Municipal Market Data's generic triple-A municipal bond.

Since the beginning of 2014, that spread has tightened to 9 basis points in five year maturities from 29 basis points. In the 15-year bonds, spreads have come down to 30 basis points from 56 basis points, and in the 30-year bonds, spreads have dropped to 37 from 62.

"California bonds have rallied as investors largely baked in continual good news," analysts at Municipal Market Advisors said in a recent report.

The state's improved financial position was boosted by the passage of Proposition 25 and Proposition 30 in 2012. Prop. 25 removed the requirement that a two-thirds vote of each house of the legislature was necessary to pass the budget.

Prop. 30 increased sales and income taxes for several years to prevent cuts to the education budget.

Despite the credit improvements, the state's ratings remain low among the states. Among Standard & Poor's ratings, California is the third lowest-ranked state. New Jersey carries an A rating and Illinois carries an A-minus rating.

"Municipal analysts recognize that the state's credit fortunes are prone to volatility, both from natural and manmade causes," MMA analysts said. "California's employee liabilities and infrastructure burdens are drags to the state's ratings upside."

The state currently has large unfunded obligations, including $57 billion for the California Public Employees' Retirement System, and $65 billion in other post-employment benefits.

The largest liability-$74 billion for the California State Teachers' Retirement System-was recently addressed in Gov. Jerry Brown's 2014-15 budget, which enacted a plan for the state, school districts, and teachers to together increase CalSTRS contributions.

MMA said other concerns for credit analysts include the state's proclivity toward real estate bubbles, as well as its other unique risks, such as the current three-year drought and recent earthquake in Napa.

"While earthquakes are a constant concern, reports of 'California's devastating drought,' low reservoir levels, and potential for fires has caused considerable analyst concern," MMA's analysts said. "A recent UC Davis report argues the drought will cost the state's economy $2.2 billion this year and lead to a loss of 17,000 jobs."

Despite these reports, MMA said the state has limited macro-economic consequences as it ranks among the top states for growth.

California has a gross state product of $2.2 trillion and is responsible for 13% of U.S. gross domestic product.

California gets its lowest score from Fitch Ratings, at A.

Fitch analysts said the rating is based on the state's institutional improvements made in recent years, its disciplined approach to achieving and maintaining structural balance in recent budgets, and the consequent fiscal progress made to date.

"Fitch believes that these gains provide the state with a greater capacity to address future fiscal and budgetary cyclicality," analysts said. "However, California's credit standing is likely to remain lower than most states for the foreseeable future given the magnitude of the state's budgetary and financial challenges, despite its key credit strengths."

All three credit rating agencies assign stable outlooks.

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.