California Bond Rally Faltering Amid Frugality Doubts

A rally that drove California’s relative borrowing costs to a five-year low is faltering as investors speculate lawmakers will squander budget surpluses with the state entering an election year.

The extra yield buyers demand on 10-year California bonds relative to benchmark municipal debt reached the slimmest since 2008 in October as a reviving economy brightened the state’s fiscal outlook, data compiled by Bloomberg show.

That may be the limit of the most-indebted U.S. state’s gains in the $3.7 trillion municipal market unless Democratic Governor Jerry Brown and lawmakers show they don’t plan to spend surpluses projected to reach almost $10 billion. Since its October low, the state’s yield spread has grown by 20 percent as investors await the January release of Brown’s next spending plan.

“It would be difficult for them to narrow much more than they already have,” Tom Metzold, co-director of munis in Boston at Eaton Vance Management, said of the yield difference. The company oversees about $28 billion of city and state debt. “All the good news is already priced in.”

Setting aside money for reserves and paying down teacher pension and retiree health-care bills would give investors more confidence, Metzold said. Brown, 75, who may run for re-election in November, will need to restrain Democrats demanding the state restore cuts to social programs reduced during the 18-month recession that ended in 2009.

Will Power

“If you go back historically, California has been a triple-A rated state before and it’s also been a triple-B rated state,” Metzold said. “It simply has to do with political will.”

Investors ask about 0.37 percentage point of extra yield to buy California debt instead of top-rated munis, up from as little as 0.3 percentage point in October, the lowest since 2008, Bloomberg data show. Even with the jump from two months ago, California bonds are on pace to beat the entire muni market in 2013, Standard & Poor’s data show. While the market has lost 2.6 percent, California debt is down 2.1 percent.

The state of 38 million people had $103 billion of gross tax-supported debt in 2012, the most among U.S. states, according to Moody’s Investors Service rankings.

With an infusion of higher income and sales levies approved last year by voters, and a surge in capital-gains tax revenue generated by profits in stocks, California expects to end its fiscal year with a $2.2 billion surplus.


The nonpartisan Legislative Analyst’s Office last month projected the surplus would swell to almost $10 billion within five years. That marks a turnaround in a state that had to pay bills with IOUs in 2009 and faced more than $100 billion of cumulative shortfalls from 2008 to 2012.

S&P raised California’s rating to A, its sixth-highest level, in January, saying policy makers had improved California’s fiscal health. It was the first time it lifted the state since 2006. Fitch Ratings followed in August with a boost to A, the state’s highest score from Fitch since 2009.

California gets 61 percent of its general-fund revenue from personal-income taxes, with about 15 percent of that from capital-gains levies. Because of that reliance on capital gains, the budget can suffer revenue swings.


The S&P 500 Index has gained almost 27 percent this year. That has poured about $5.2 billion more into state coffers than what Brown projected in May. The S&P index fell about 38 percent in 2008, leaving California with a record $42 billion budget shortfall.

California has a history of failing to plan for boom-and-bust cycles. The state enjoyed a $12 billion budget surplus in 1999 and chose to spend it mostly on existing programs. Four years later, it faced a $35 billion shortfall without a rainy-day fund.

“While we expect revenue to climb and then snap back, what we really need to have is nice reserves so those peaks balance out,” said Michael Johnson, managing partner of Gurtin Fixed Income Management LLC, which oversees $7.5 billion in Solana Beach, California.

Brown has made progress in easing California’s year-over-year budget shortages. Last fiscal year, the state chipped $7.3 billion from what the governor called a “wall of debt,” or recurring borrowing to plug deficits. His current budget calls for paying off about 30 percent of the remainder by the end of June.

June Record

In June, he convinced Democrats who control both chambers of the legislature to back off demands to begin spending the growing surplus and instead pass a $96.3 billion budget, up less than 1 percent from the previous year.

“The one thing I am absolutely certain of is that Governor Brown intends to maintain that course,” California Treasurer Bill Lockyer said in a phone interview.

The governor now faces the challenge of restraining lawmakers with a surplus predicted in an election year.

“It’s the nature of politics that it’s never been in anyone’s best interest to run a surplus and keep that surplus set aside,” Metzold said. “Governor Brown has been extremely diligent, but the question is, how much political will does he have with the rest of his political party?”

Pension Liability

“Continuing to pay down debt and having a significant budget reserve are priorities for this governor and this administration,” said H.D. Palmer, a finance department spokesman. “You can fully expect the governor to build upon the progress that we’ve achieved over the last three years when he submits his budget to the legislature next month.”

Brown also has yet to resolve $71 billion in unfunded liabilities for the second-largest U.S. pension, the California State Teachers’ Retirement System.

Unlike the California Public Employees’ Retirement System, the nation’s largest plan, with $270 billion of assets, the Calstrs board doesn’t have authority to set contribution rates from teachers, school districts and the state. Changes can only be made through state legislation.

California pays about 5 percent of teacher payroll into Calstrs. School districts provide 8.25 percent of payroll, while teachers and other employees surrender 8 percent of their pay. The rate hasn’t changed for employees since 1972. For the districts, it’s been the same for more than two decades.

“We see the forecasts and the way it is going and if there is not a significant adjustments to the teachers pensions, it will implode in about 30 years,” Lockyer said.

Surplus Fate

To eliminate its funding gap, the $167 billion teachers fund has said it would need as much as $4.5 billion more annually for three decades. That would mean teachers, districts and the state would need to increase annual contributions by 15 percent combined.

“If Calstrs is going to turn to the state for a bailout, those surpluses don’t exist,” said Scott Minerd, who oversees about $190 billion as global chief investment officer of Guggenheim Partners LLC in Santa Monica, California.

In the municipal market this week, Foothill/Eastern Transportation Corridor Agency, operator of toll roads in California’s Orange County, joins issuers nationwide selling a combined $13 billion of debt with yields close to a three-month high.

Top-rated 10-year munis yield 2.96 percent, compared with 2.84 percent on similar-maturity Treasuries.

The ratio of the interest rates, a measure of relative value, is about 104 percent, compared with a five-year average of 102 percent. The higher the figure, the cheaper munis are compared with federal securities.

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