A heady bond market is primed to absorb Washington's competitive GO deal
Continued heady demand for high-quality tax-exempt bonds puts the Washington State Treasurer’s office in the comfort zone as it prepares to auction $800 million in general obligation bonds next week.
If demand was weaker, the finance team may have considered splitting the deal into smaller competitive sales or conducting a negotiated sale, said Jason Richter, the state's debt manager.
“It’s a seller’s market,” Richter said. “I feel that we are going to have really strong demand for our financing. If we were issuing a large deal and the market was softer, I think there would be more concern about whether we were going to get the demand for a deal of this size selling the bonds in a competitive auction.”
Wednesday's auction for the $619.7 million Series 2020 C bonds will run until 7:30 a.m., the $60.2 million Series 2020D bonds will run until 8 a.m. and the $120.4 million 2020E bonds will sell until 8:30 a.m.
Montague DeRose and Associates LLC and Piper Sandler & Co. are the municipal advisors and Foster Garvey is bond counsel.
The proceeds of the bonds will be used to pay and reimburse state expenditures for capital projects, transportation-related projects and for construction of state and local highway improvements and preservation projects, including those that fall under the “Connecting Washington” program.
Previous state treasurers favored competitive sales over negotiated deals, but Richter said the current team weighs the advantages of one over the other as it sets the bond calendar.
“It is something we spend quite a bit of time talking about,” Richter said. “The state has a longstanding history of relying on competitive sales and it has worked out for the state.”
Michael Murphy, who was treasurer from 1997 to 2009, always sold bonds competitively. James McIntire, state treasurer Duane Davidson’s immediate predecessor, infrequently sold bonds in negotiated deals, but also favored competitive sales.
“Our general obligation issues are pretty straightforward, but I have wanted to push the retail outreach a little bit to expand our investor base, because it strengthens our position in the market,” Richter said of why the state has brought more negotiated deals in Davidson’s tenure, which began in 2017.
In a competitive bid, the issuer accepts bids, typically through an electronic platform, at a certain time on a predetermined date and the underwriter offering the highest price, in other words the lowest interest rate, wins the bonds. In a negotiated sale, the underwriter is often selected through a request for proposal process, and then the issuer works with their financial advisor and underwriter to negotiate bond prices for each maturity.
Common wisdom says that competitive sales work best on straightforward bonds with well-known issuers, while negotiated is the best way to sell bonds with a “story,” or some level of complexity that might need to be explained to investors. Competitive bonds also don’t allow for a retail order period and it’s more difficult to respond to changing market conditions.
In a negotiated sale, the underwriter contemplates the optimal structure including premiums, discounts, term bonds and potential call features a week or two ahead of the pricing date.
With demand for tax-exempt bonds so strong, the factors that favor one method of sale over another are lessened, said Matt Fabian, a partner at Municipal Market Analytics.
“Competitive loans can be used to rally the market in the primary, but in conditions like this, the market has all the rally it can handle,” Fabian said.
Because dealers have been working for less money on negotiated deals, the cost of capital might be similar, Fabian said.
Negotiated deals have historically been considered to be more costly because of underwriting costs, the tradeoff being that negotiations had the potential to result in reduced interest costs because of pre-marketing.
Washington has AA-plus ratings from both Fitch Ratings and S&P Global Ratings. It received an upgrade to Aaa from Moody’s Investors Service in August.
The upgrade came in the face of troubles at the firm that used to be Washington's economic bellwether, Boeing, which has been in turmoil since suspending production of its bread-and-butter airliner, the 737 Max, after two crashes raised doubts about its safety.
Karen Ribble, a Fitch Ratings senior director, said Boeing's troubles haven’t affected revenues in a state where more contemporary businesses have taken the lead.
“As I noted in my report, Amazon and Microsoft employ 50% more than Boeing,” Ribble said. “Those two by far exceed Boeing. The state is not as reliant on Boeing as it used to be.”
As it’s highly-rated, Fabian said yields are going to be low. Investors will also favor it, he said, because they won’t be competing with specialty state demand from Washington residents as the state doesn’t have an income tax.
There is so much demand for tax-exempt bonds right now that Fabian said he would be hard put to think of a deal that wouldn’t generate investor interest.
“At this point, the benefit of an upgrade is more psychological than financial,” Fabian said. “It will make some difference, but as far as the cost of capital in the primary market, a ratings upgrade matters less today than it mattered before.”
The state has so many factors weighing in its favor that it would be tough to tease out how much of investor demand is due to the ratings upgrade and how much to other factors, Richter said.
“We have seen spread compression on our deals,” Richter said. “Washington’s economy is one of the best in the country. We have Microsoft, Amazon and Costco headquartered here. Boeing is going through some tough times, but we expect they will be back to firing on all eight cylinders again soon.”
Not to mention the state’s pensions are funded at 89% and it has strong reserves, Richter said.
Washington’s AA-plus general obligation bond rating reflects “the state’s exceptionally strong economy with solid revenue growth prospects, a demonstrated commitment to fiscal balance and combined long-term liabilities that place a low burden on resources,” Fitch analysts said in a ratings report ahead of the sale.
Though the ratings report said the state had elevated debt ratios, the state’s pension liability is moderate. So the combination of its debt and pensions put the figure at less than 10% of personal income, which is Fitch’s threshold for triple-A states, Ribble said.
“The population and personal income are growing,” Ribble said. The debt stems from investments and transportation and other areas to support population growth, which makes the debt less of a concern, she said.
Washington had about $19.3 billion in GO bonds outstanding as of June 30, 2019, according to an Oct. 18 S&P report. Of this about $6.8 billion of the state’s net GO debt is payable first from excise taxes on motor vehicles and special fuels. Tax supported debt is moderately high at 4.1% of personal income, according to S&P.
Washington is one of nine states that does not currently impose a personal income tax or capital gains tax, according to S&P. Together, retail sales and business and occupation tax, account for a combined 71% of general fund tax revenues in fiscal 2018, 73% is forecast for fiscal 2019, S&P analysts wrote.
The state’s strong revenue forecasting and budget control will allow the state to continue to address the challenges while maintaining fundamental financial flexibility even in a moderate economic downturn scenario, according to Fitch’s rating report.