California Bonds Mirror Turnabout as Market Prices Near AAA

Updated on
  • Ten-year yields hover at lows amid high demand for municipals
  • State reaps benefits of economy, negative global rates

California’s a golden child for the municipal-bond market.

As the state sold $2.7 billion of general-obligation debt Tuesday, the government is being rewarded by investors for a fiscal turnaround that’s left it with budget surpluses and the highest credit rating since 2001, before the full brunt of the dot-com stock bubble’s collapse. The new 10-year securities were priced to yield 1.63 percent, according to data compiled by Bloomberg.

"The state is doing great. It’s riding a wave of multiple years of growth," said Kathleen Meyer, senior portfolio manager at City National Rochdale, which manages $4.7 billion in tax-exempt municipals and may buy some of the new securities. “If the state continues on an upward trajectory, there’s no doubt in my mind that we can see” rates below those on benchmark municipals, she said before the sale.

The most-populous U.S. state is among those reaping financial gains as turmoil in financial markets and negative interest rates overseas hold municipal-bond yields -- which move in the opposite direction as price -- at the lowest in decades. The rally has persisted even as states and cities head toward issuing the most debt since 2010’s record year.

While municipals are largely bought by U.S. residents interested in tax-exempt income, the market has seen an influx of foreign investors looking for better returns, said Bernhard Fischer, senior fixed-income analyst at Principal Global Investors, which holds $6.5 billion of municipal bonds.

"The market dynamic right now represents a significant supply-demand imbalance," said Fischer, whose firm may buy some of the debt. "That’s quite a bit of irrational pricing across the market now."

Because of the turnaround in California’s finances, demand for the state’s bonds has been particularly brisk. The yield on its 10-year bonds is lower than those issued by Texas and Florida, both of which are ranked AAA by S&P Global Ratings, three steps higher than California.

Further gains by California relative to other states may be limited because some investors may hold too many general obligations and others may sell while prices are high, Fischer said. One of the deal’s underwriters -- Ramirez & Co. -- advised clients in a note Monday that the new bonds may be issued for yields higher those currently trading, though they may rise in price after being issued.

The securities “will likely trade up on the break,” Ramirez analyst Peter Block wrote.

The sale by California -- nicknamed the Golden State because of the 19th century mining boom -- came after Fitch Ratings raised it to the fourth-highest investment grade on Aug. 12, citing strong revenue growth and financial management.

Actions such as socking away more cash in reserves and implementing temporary tax increases have helped state officials turn around a spate of budget deficits into surpluses to the approval of ratings companies. Their tasks have been made easier as the economy benefits from Silicon Valley’s technology industry and a real-estate market revival. The state, which had to pay bills with IOUs in 2009 because borrowing would have been too costly, has been so flush with cash that for the past two years it hasn’t issued short-term notes, a common practice among governments waiting for tax collections to come in.

There are signs, though, that California’s bull run may be slowing. With income-tax revenue dominated by the wealthiest, who tend to own stocks, California is highly susceptible to equity-market swings. July and June collections of its top two taxes were lower than estimates, according to State Controller Betty Yee. In May, the state reduced its forecast for revenue for the year that began in July by $1.9 billion.

Still, California’s actions to lay down fiscal discipline on itself will make it better prepared should the economy weaken, according to Fitch, which said it’s "unlikely" the state would scramble as much as it did during the recession that ended in 2009.

"The state is better positioned today for an economic downturn than it has ever been," said Principal’s Fischer.

(Updates with sale details in the second paragraph.)
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