California Rides Fiscal Tailwinds With Debt Rally: Muni Credit
California heads to Wall Street this week to borrow for the first time since the most-populous U.S. state earned a credit-rating boost in January, as buyers push its debt close to the strongest in more than four years.
The relative borrowing cost for issuers in the state has been cut in half since Governor Jerry Brown took office in 2011 and began whittling down chronic deficits. Standard & Poor’s raised the state’s rating Jan. 31 for the first time since 2006 after voters agreed to increase taxes on income and sales. The 74-year-old Democrat has proposed a budget with a surplus, California’s first in almost a decade.
The extra yield over top-rated municipal bonds that investors demand to own 10-year debt of the state and its localities was about 0.56 percentage point last week, close to the slimmest since November 2008, data compiled by Bloomberg show. The improving fiscal outlook is luring investors even after three municipalities in the state filed for bankruptcy protection last year.
“California has the wind at its back,” said Bill Delahunty, director of muni research in Boston at Eaton Vance Management, which oversees about $30 billion in local debt. “The potential does exist for spreads to tighten further, especially if the economy continues to grow and do well.”
Treasurer Bill Lockyer tomorrow begins marketing $2.4 billion of taxable and tax-exempt general obligations to individual investors, in the state’s largest sale since October 2011. The deal wraps up March 14 with bidding from institutional investors such as mutual funds. California also plans to remarket $228 million of taxable Build America Bonds March 13.
Nationwide, local governments are scheduled to offer about $10 billion of long-term debt this week, the most this year, data compiled by Bloomberg show.
Towns, cities and states are borrowing as a strengthening labor market and rallying stocks have pushed benchmark muni interest rates to the highest in months. Yields on 20-year general obligations rose to 3.86 percent last week, the highest since July and up from a generational low of 3.27 percent set in December, a Bond Buyer index shows.
The interest rate is still down from a 30-year average of about 5.9 percent, allowing Lockyer and other local finance officials to retire higher-cost debt. About half the general obligations California is offering will refinance higher- yielding bonds. He’s already said he will borrow more in April, including more refunding.
Brown and labor unions spearheaded a successful voter initiative in November that increased levies on income starting at $250,000 -- reaching 13.3 percent on those making $1 million or more, the most of any state. The measure also pushed the statewide sales tax to 7.5 percent, the highest of any state.
For California investors paying steeper taxes, buying tax- exempt bonds would help lower their liability.
“With the tax rates that exist now at the state level combined with the federal tax rate, there shouldn’t be a shortage of investors -- particularly within the state -- that have interest,” said Jamie Iselin, head of munis at New York- based Neuberger Berman Group LLC. The company oversees about $11 billion in local debt.
Iselin, however, is among portfolio managers wary of adding California securities with yield spreads down to about half their five-year average.
“There’s not a lot of room left for spreads to tighten,” said Iselin. “It wasn’t too long ago that their bonds were trading well over 100 basis points over high-grades.”
S&P in January lifted the state’s credit one step to A, the sixth-highest level, raising it out of a tie with Illinois for the lowest-rated U.S. state. Fitch Ratings followed this month, changing its outlook on California to positive from stable, meaning it is in line for an increase.
The state’s borrowing costs have declined even as it faces federal spending reductions this year as part of automatic cuts that went into effect nationwide at the start of March. The state will lose about $88 million of education funding this year under what’s known as sequestration, according to the White House.
“The muni market is very retail-dominated, which tends to be affected by a lot of news and headline risks,” said Michael E. Johnson, managing partner at Gurtin Fixed Income Management LLC in Solana Beach, California, which manages $4 billion in munis.
“People have gotten over the issues that the media has put out there about California,” he said. “People are really starting to realize the uptick in credit quality.”
Still, he said money managers may demand wider yield spreads than current levels as the deal prices.
California tax-exempt bonds due in April 2042 traded March 8 with an average yield of 3.52 percent, or about 0.56 percentage point above benchmark munis, Bloomberg data show. The spread was about 0.96 percentage point when the bonds priced in April.
“While we think it’s an improving credit situation, our involvement will completely depend on pricing and where it comes,” said Robert Miller, a senior portfolio manager in Menomonee Falls, Wisconsin, at Wells Capital Management, which oversees about $32 billion in munis.
“The bonds are trading like they’re going to get upgraded to AA,” he said. “We sold into that thinking that there might be an opportunity to reload.”
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