California `Budget Kabuki' Increases Schwarzenegger Debt Costs

California’s borrowing costs are rising, even as Governor Arnold Schwarzenegger says he’s not ready to call lawmakers into special session to eliminate a $19.1 billion deficit before the state runs out of cash.

The extra yield investors demand on 10-year California bonds rose to 124 basis points above AAA rated municipal securities yesterday, up 14 percent in a week, Bloomberg Fair Value Index data show. The increase comes as the state will need to borrow as much as $10 billion in short-term notes within four weeks of any budget agreement and more than $6 billion in longer-dated bonds by December for public-works projects.

California hasn’t had a budget since the fiscal year began on July 1. Schwarzenegger, a Republican, yesterday said he would resume private negotiations with Legislative leaders after lawmakers rejected a pair of dueling deficit-cutting plans and then adjourned for the year. The state may need to issue IOUs to pay bills by next month and Standard & Poor’s has said it may cut California’s A- rating, already the lowest among states.

The “budget Kabuki did not bring us any closer to a solution, but it did highlight the fundamental and critical differences about how to close our deficit and bring our economy back,” Schwarzenegger told reporters yesterday in Sacramento.

California last sold general-fund backed bonds in June, when it offered about $120 million of debt for veteran’s homes. The state sold $450 million of public works bonds in May and $5.9 billion of debt in March.

The state’s credit grade may be cut if the stalemate continues for several months or more, S&P said in June. A lower rating may add to California’s borrowing costs.

CDS Rates Rise

The stalemate also has forced up the price of credit- default swap contracts on California bonds. A contract maturing in 10 years rose to about $300,000 to protect $10 million of bonds on Aug. 31, the highest since July 12, according to data compiled by Bloomberg. The cost slipped to $295,000 yesterday.

“We’re waiting it out,” said Kenneth Naehu, a managing director at Bel Air Investment Advisors in Los Angeles. He manages almost $3 billion in municipal bonds.

“We don’t have to chase yield,” Naehu said yesterday in a telephone interview. “California general-obligations, if they get downgraded, could go 150 basis points over high grades versus 124 now.” A basis point is 0.01 percentage point.

Yields on top-rated tax-exempt municipal debt due in 10 years rose 3 basis points yesterday to 2.61 percent, the second rise in yields since June 15, according to data from Concord, Massachusetts-based Municipal Market Advisors. The first increase since June, also of 3 basis points, was on Aug. 27.

Record Lows

Municipal interest rates were driven to record lows last month as investors sought the perceived safety of the market amid concern that the economic recovery may be slower than expected. Yields fell about 10 percent in August, to 258 basis points on Aug. 25 from 286 basis points on July 30. A yield of 2.58 percent is the lowest ever, according to MMA data dating to January 2001.

“My thought is that it may be more directly related to the general market movement and that it’s not a direct consequence of the budget impasse,” state Treasurer Bill Lockyer said in a telephone interview.

California requires a two-thirds vote in both legislative chambers to pass budgets, and neither Republicans nor Democrats hold enough seats to meet that threshold. Schwarzenegger and Republicans want to dismantle the state’s main welfare program and slash $12.4 billion of spending. Democrats proposed $5.9 billion in higher taxes and fees combined with spending cuts.

Constitutional Deadline

California’s constitution says lawmakers must send a budget to the governor by June 15, a deadline they’ve met five times in the last 30 years. The 2008 budget was enacted 85 days into the fiscal year, the latest ever. The second latest was signed into law Sept. 5, 2003.

Absent a budget, the state can’t sell the short-term notes it typically uses each year to bridge cash shortages, because repayment of the debt must be part of an approved spending plan. Chiang and Schwarzenegger’s department of finance have said the state may need to borrow as much as $10 billion on a short-term basis once a budget is signed. The state sold $8.8 billion of such notes in September and repaid the loan June 23.

“It’s harder to finish the fiscal year with a sizable cash-flow surplus,” Lockyer said. “And without a significant surplus at the end of the year, bond investors tend to be a little bit more anxious and the cost of borrowing increases.”

Following are descriptions of pending sales of municipal debt in the U.S.:

MINNESOTA, which sold $865 million in debt through a competitive sale last month, plans to issue about $900 million in tax-exempt refunding bonds as early as next week. RBC Capital Markets, which won the bidding on $635 million of the August issue, will lead underwriters in marketing the latest sale to investors. The state’s general-obligation bonds carry top ratings from S&P and Fitch Ratings, and Aa1 from Moody’s Investors Service, one level lower. (Added Sept. 1)

ARKANSAS STUDENT LOAN AUTHORITY, which helps state students finance higher education, plans to sell $267.5 million in asset- backed notes as early as next week. The interest on the floating-rate securities will be based on the three-month London interbank offered rate, or Libor, the rate at which banks borrow from other banks. The benchmark stood at 0.296 percent yesterday. The securities must receive top ratings from Moody’s and Fitch before they can be issued, according to preliminary offering documents. RBC Capital Markets and Bank of America Merrill Lynch will underwrite the offering. (Added Sept. 2)

NORTH CAROLINA EASTERN MUNICIPAL POWER AGENCY, a wholesale power supplier to 32 cities and towns, plans to sell about $170 million in tax-exempt bonds Sept. 8 to refinance existing debt. The offering, rated by A- by S&P and Fitch, the fourth-lowest investment grade, will be marketed by underwriters led by Citigroup Inc. (Updated Sept. 2)

To contact the reporter on this story: Michael Marois in Sacramento at mmarois@bloomberg.net.

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