California Costliest Since ’08 Seen Spooking Buyers: Muni Credit

The biggest rally in five years in California debt has some investors balking on concern that the state’s finances are increasingly vulnerable to swings in the economy and tax revenue.

The most-populous state is selling $2.2 billion in general obligations starting today, its largest such offer since April, according to data from the treasurer’s office. Record strength in its economy and tax boosts championed by Governor Jerry Brown have earned credit-grade increases this year from Standard & Poor’s and Fitch Ratings. It hasn’t had a higher mark from Moody’s Investors Service since 2001.

Yet at 0.31 percentage point, the extra yield investors are willing to accept on 10-year California bonds has shrunk to the skimpiest since 2008, data compiled by Bloomberg show. The spread is less than that on debt from Michigan, with a rating two steps higher. For some buyers, the cushion isn’t enough, given that the fiscal gains are tied to volatile revenue such as capital-gains taxes.

“It’s definitely less attractive,” said Michael Johnson, managing partner of Gurtin Fixed Income Management LLC, which oversees $7.5 billion in Solana Beach, California. “It still provides more yield than a lot of places in the market, but spreads have come in so tightly that it’s certainly less attractive than it has been.”

Ratings Action

Fitch raised California to A, sixth-highest, in August after lawmakers passed a $96.3 billion budget in June that incorporated the 75-year-old Democratic governor’s more conservative revenue forecasts and set aside a $1.1 billion reserve. He also forecast a surplus this year, the first in almost a decade. S&P raised the rating to the same level in January, the first boost since 2006. Moody’s grades it four steps below the top.

California securities are beating the $3.7 trillion municipal market amid the worst year for local debt since 2008. The state’s bonds have earned about 0.3 percent in the past three months, while the rest of local borrowings lost about 0.4 percent, S&P data show.

The yield spread on California obligations is down from a peak of about 1.7 percentage points in July 2009, when an impasse over how to close a budget deficit led the state to issue IOUs to make ends meet, Bloomberg data show.

The state is “trading as if it’s going to be upgraded,” said Tom Metzold, co-director of municipal investments in Boston at Eaton Vance Management, which oversees about $28 billion in local debt. “I’m not as sanguine about California.”

Gamut Run

California “has been everywhere between AAA and BBB,” two levels above junk, in the past 35 years, Metzold said. “Maybe it’s already topped out.”

Investors may have a different view, in light of the recent crisis over the partial government shutdown and the U.S. debt ceiling, said Tom Dresslar, a spokesman for Treasurer Bill Lockyer.

“Investors may be able to distinguish between California, which has made great strides to improve its fiscal management and standing, and the weaknesses of the federal government,” Dresslar said.

Sale Week

The world’s ninth-largest economy is scheduled to sell tax-exempt and taxable obligations, according to Lockyer’s office. The debt will be offered to individual investors today and institutions such as mutual funds tomorrow, with final pricing that day.

Proceeds will go toward building schools, parks and libraries, to retrofit buildings against earthquakes and to refinance some higher-cost debt.

In preliminary marketing today, the state is offering 10-year debt at 3.15 percent, or about 0.32 percentage point above benchmark securities, according to a person familiar with the sale who asked not to be named because the deal isn’t final.

In April, California sold debt maturing in 2023 to yield 2.37 percent, or about 0.54 percentage point above top-rated munis, Bloomberg data show.

Returns on California general obligations may be limited after the rally of the past year, said Jim Schwartz, head of muni research at BlackRock Inc., which oversees about $108 billion of local debt. California will still find demand from in-state individuals seeking tax-exempt income, he said from New York.

Brown’s Victory

In November, voters approved Brown’s proposal to boost the statewide sales tax and increase levies on income of $250,000 or more. Income taxes have accounted for about 63 percent of revenue this fiscal year, according to the Finance Department.

By increasing reliance on levies on top earners, including capital gains, California has made itself more vulnerable to fluctuations in the economy, said Emily Raimes, a Moody’s vice president.

Moody’s A1 rating -- second-lowest for a state, after Illinois -- recognizes California’s sensitivity to boom-and-bust cycles, she said.

A strengthening economy alone won’t earn California a higher mark, absent changes that make revenue less volatile or require lawmakers to set aside a larger financial cushion, Raimes said in an interview.

“We don’t want or expect their rating to go down when their finances go down or go up when their finances go up,” Raimes said.

Revenue Key

S&P could raise California again if revenue beats projections consistently and Brown and lawmakers work to reduce the state’s long-term debt burden, said Gabriel Petek, a senior director in U.S. public finance in San Francisco.

California had about $103 billion of gross tax-supported debt in 2012, ranking it first among U.S. states, according to Moody’s. It placed seventh on a debt per capita basis.

California’s two largest revenue sources -- taxes on income and sales -- both exceeded projections in Brown’s budget by more than 9 percent in September, according to an Oct. 16 bulletin from the state Finance Department. Since the fiscal year began in July, general-fund tax collections have outpaced Brown’s estimates by 0.7 percent, the department said.

A Federal Reserve Bank of Philadelphia index tracking California’s economy was the highest since at least 1979 in August. At the same time, the jobless rate was 8.9 percent that month, exceeding the 7.3 percent national average.

Stocks Signal

The best predictor of California’s revenue is the performance of the stock market, Jason Sisney, deputy state legislative analyst for state and local finance, said at the Bond Buyer’s California Public Finance Conference in Los Angeles Sept. 25.

The S&P 500 index of shares has gained about 22 percent this year, after a 13.4 percent increase in 2012.

The state is equivalent to a company whose performance depends on the economic climate, BlackRock’s Schwartz said.

“During good times, they look like an AA, and in bad times, they look like a BBB,” he said.

California’s sale is among $7.5 billion of long-term muni issues scheduled this week. It’s the busiest slate since July, and is up from $4.3 billion last week as borrowing climbs after the deal to raise the U.S. debt ceiling.

Ten-year benchmark munis yield 2.83 percent, the highest since Sept. 20.

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