California’s Next Big Task

Despite the fanfare surrounding the passage of the $15 billion economic recovery bond measure in California last week, the state and its underwriting team now face significant challenges in structuring and marketing what will be the largest municipal bond issue in U.S. history.

Thirty-year, 5% coupon California general obligation bonds rallied following last Tuesday’s Proposition 57 vote and were trading around par on Thursday, nearly a 5-basis-point improvement from Monday’s levels, according to traders. On Friday morning those bonds were trading at 4.90% yields after a disappointing February employment report sent Treasuries skyrocketing.

Some accounts at Stone & Youngberg LLC in San Francisco that had stopped buying California bonds as they awaited a resolution of the state’s fiscal crisis returned to the market last week after the measure was passed, said Dean Gestal, a managing director at the firm.

“There’s resolution in the air,” Gestal said. “For the first time in more than a year … there is some form of positive direction that we can believe in that will get us out of this quandary.”

Mired by a massive budget deficit, California has suffered a series of downgrades from rating agencies that made it the lowest-rated state in the nation. But Standard & Poor’s placed the state on CreditWatch with positive implications following the vote. It had previously assigned a stable outlook to its BBB rating.

Moody’s Investors Service meanwhile also changed its outlook on the Baa1 rating it assigns California to stable from negative. Fitch Ratings, which rates the state BBB, did not change its negative rating watch following the vote.

While the bond plan is a step in the right direction for the cash-strapped state — allowing it to meet almost $14 billion in payments for revenue anticipation notes and warrants that mature in June and thereby avoiding a near-term crisis — it does not solve structural budget imbalances, analysts say. There are some investors whom the state may still be far from enticing to buy its bonds, a fact it will have to contend with as it prepares to bring its record-size deal to market.

Joe Deane, a managing director at Citigroup Asset Management in New York and portfolio manager of the firm’s $918 million California municipal bond mutual fund, said he has been reluctant to buy the state’s bonds. With almost no exposure to California GOs, the fund could be like “dry wood” for the state, capable of buying up to $300 million of its bonds, Deane said.But it will take more than the bond plan to convince Deane to buy the state’s bonds.

“The $15 billion bond takes the state out of crisis mode, but it doesn’t put into a no-problem scenario,” said Robin Rappaport, senior municipal strategist at Payden & Rygel, in Los Angeles. “There still is a significant structural deficit, and the state needs to address it either through spending cuts or some sort of revenue enhancement.”

“It’s a good first step,” Deane said. “But at the moment, I want to see a little bit more information as to how they’re going to balance the budget … that’s where the rubber meets the road.”

The planned pledge of a quarter-cent sales tax as added security to the state’s full faith and credit should help attract additional demand, according to analysts. The extra security could mean the economic recovery bonds will receive higher ratings than the state’s GOs. Some institutional investors have been prohibited from investing in the state’s GOs based on internal guidelines that bar them from buying bonds rated BBB or lower.

In a lawsuit filed on Wednesday, a group of 48 cities challenged the state’s use of the sales tax stream because it is being diverted from local governments, even though they are meant to be reimbursed through property tax funds. California Treasurer Phil Angelides said the challenge would not necessarily stop the bond issuance, which has been scheduled for June.

Because the double-barreled pledge will essentially distinguish the economic recovery bonds from the state’s GO bonds as a slightly different type of credit, market observers speculate that bond insurance companies are likely to have more capacity to insure the deal, a factor that could further broaden the bonds’ appeal.

But the state may face more hurdles in structuring the deal so that it attracts enough demand to achieve low interest costs. Officials have indicated they plan to assign maturities ranging from nine to 15 years to the bonds, possibly limiting interest to those investors who buy within those maturities.

Phil Fang, portfolio manager of the Jersey City-based Lord Abbett & Co.’s $192 million California municipal bond mutual fund, said that since he only invests in longer-term bonds, it’s unlikely he would be buy any of the economic recovery bonds.

While 20- and 30-year California GOs rallied, intermediate-term bonds went almost unchanged, traders said. Unlike the state’s longer-term bonds, which benefited from the positive credit implications of last week’s vote, intermediate-term California GOs remained stable due to the expected surge of supply the economic recovery bonds would generate in that maturity range, according to Philip Condon, a managing director at Deutsche Asset Management in Boston.

But market participants believe some of the bonds would carry short-term puts and be sold at floating rates in order to broaden demand. The state announced on Thursday that Lehman Brothers had been selected as book-running senior manager for the deal to lead a syndicate composed of 10 firms.

Also important to the deal’s success will be its ability to garner enough demand from individual retail investors.

California retail demand has waned in recent months due to the absolute low level of yields and the belief that interest rates may rise higher, according to Warren Gordon, director of fixed-income trading at Charles Schwab & Co. in San Francisco. But the intermediate maturities planned for the economic recovery bonds may bode well for the sale, as many retail investors have been avoiding longer-term bonds, whose prices are often more sensitive to changes in interest rates, Gordon said.

A release issued by Angelides’ office late Thursday said the state had opted to sell the economic recovery bonds through a negotiated sale, which utilizes underwriters’ marketing and distribution capabilities and would allow the state to hold a retail order period. By selling $2 billion in GOs last month via a negotiated sale, the state — which has typically relied on competitive sales for its GO bonds — achieved what it believed to be a record $900 million in retail orders for a GO bond, a key factor in that deal’s success.

On Thursday, California GO bonds maturing in 15 years were trading at yields 62 basis points higher than Municipal Market Data’s 15-year, triple-A rated GO benchmark, down from an 83-basis-point spread in July 2003 — the widest level since the firm began tracking the data in 1993.

That is dramatically different from September 2000, when 15-year California GOs traded at yields 28 basis points lower than MMD’s 15-year triple-A GO benchmark, while the state was still flush with cash in the wake of the technology boom.

Payden & Rygel’s Rappaport said she expects the recent spread narrowing to continue as the state begins to put financial uncertainty behind it. “But,” she added, “I don’t think we’re going to see levels that we saw a few years ago for a long time.”