California comes to market Tuesday with the inaugural sale of an income tax revenue bond credit that will provide funding to house homeless people with mental illnesses.
Bookrunners Raymond James and Citi are leading a 13-bank syndicate that will price the $500 million taxable deal from the California Health Facilities Financing Authority. Montague De Rose & Associates is the financial adviser. Orrick is bond counsel.
The deal marks the first sale under the No Place Like Home bond legislation signed by former Gov. Jerry Brown in 2016. The program gives the state $2 billion in bond authority to provide funding to cities and counties to develop permanent supportive housing.
Bonds are repaid with revenue from the Mental Health Services Act, a measure approved by voters in 2004 that levies a 1% tax on personal income over $1 million to be used for mental health programs.
“The most intriguing part about the deal is that it is a most interesting experiment to see whether a large-scale attack on homelessness associated with mental illness will bend the curve,” said Tim Schaefer, deputy treasurer for public finance.
In June, the state’s Department of Housing and Community Development, which administers the program, awarded $179 million to developers for 2,100 units of supportive housing in 37 communities across the state, according to a release. That came on top of $508 million given in March to Santa Clara, San Diego, San Francisco and Los Angeles, which are administering their own competitive funding programs.
“We all deserve a good and secure home and we have an enormous opportunity with this program to change the lives of some of our most vulnerable Californians,” HCD Director Ben Metcalf said in a statement.
California had the largest population of homeless people in the nation at 129,000 as of December 2018, according to a U.S. Department of Housing and Urban Development
Mental health concerns affected 78% of the unsheltered population of homeless people in a national study conducted by the California Policy Lab at UCLA
The No Place Like Home bonds were stalled when Mary Ann Bernard, a retired attorney, filed a lawsuit arguing that the law constituted an illegal use of MHSA money. Attorney General Xavier Becerra, who represented the CHFFA and the Department of Housing and Community Development, which runs the program, filed a motion to validate the bonds.
Brown and state lawmakers decided not to wait for the courts; they placed a measure on the November 2018 ballot to specifically authorize the bonds. Proposition 2 passed with more than 63% voting in favor. It authorizes the use of $140 million annually of the mental health tax to support up to $2 billion in bonds.
Sacramento County Superior Court Judge Stacy Boulware Eurie issued an order validating the bonds Sept. 26, but Bernard has since filed an appeal that has not been resolved.
Becerra and Orrick both included legal opinions validating the sale of the bonds in the bond documents “even though the appeal is expected to be ongoing when the 2019 bonds are issued and delivered to the underwriters,” according to the preliminary offering statement.
Given the bonds are taxables and a first-time issue for the credit, institutions, rather than retail buyers, are expected to dominate sales.
“It requires some clear understanding of how the true-up works and the fact that additional bonds will be sold in the future,” Schaefer said. “That is a level of sophistication that retail investors are capable of understanding, but because it is a debut credit, it will take more time for retail investors and brokers to become familiar with them. With a debut credit, institutions usually buy it first, because they have the horsepower to do the analysis, research it and understand it.”
The debut senior revenue bonds received an Aa3 rating from Moody’s Investors Service and AA-minus ratings from both Fitch Ratings and S&P Global Ratings. All assigned stable outlooks.
Fitch and Moody's rate the credit one notch below their California GO rating. Fitch cites a complex system of transfers and true-ups between the general fund and the Mental Health Services Fund.
Fitch upgraded California GOs one notch to AA in August, and Moody's raised them to Aa2 from Aa3 in October. The state holds S&P's AA-minus rating.
The 1% "millionaire’s tax" is collected by the state Franchise Board with the personal income tax and deposited in the general fund. An amount equal to 1.762% of net PIT tax receipts are transferred to the MHSF monthly as an approximation of the liability of the tax.
The bonds are secured by loan payments from the state housing department to CHFFA, a conduit bond issuing arm of the state treasurer's office. HCD will make the loan payments from service contract payments it receives for providing services under the contract with CHFFA. The conduit will pay the service contract payments from the dedicated personal income tax revenues.
Tax collections for the 1% surcharge are volatile. They increased from $895 million in 2006 to a peak of $1.4 billion in 2008, before falling by 39% during the recession, according to Fitch. Revenues have recovered since bottoming out at $846 million in 2012 to $2.1 billion in 2018 to provide 15 times coverage for the $140 million annual debt service permitted under the act, Fitch wrote.
“Assuming full leveraging to the $140 million cap on the annual service contact payments that will be used for debt service, pledged revenues can sustain a high level of decline and still maintain ample debt service coverage,” Fitch wrote.
California’s tax revenues grown during the period of economic expansion at a pace that approximates national gross domestic product growth, said Fitch, which added that it expects this trend to continue.
“The millionaire’s tax has grown at an even more rapid pace,” Fitch analysts wrote in the pre-sale ratings report. “Over the 13-year collection period, the 1% millionaire’s tax has grown at a 7.5% compound annual growth rate.”
Matt Fabian, a partner with Municipal Market Analytics, expects the bonds will see more interest from institutional buyers because the bonds are taxable, even though they are California tax-exempt.
The bonds are being sold as social impact bonds because they fit the International Capital Market Association’s criteria, according to bond documents, but the label is self-designating and not affirmed by an outside party.
The designation may attract a few investors and could provide a liquidity benefit in the future as social impact and environmental social governance bonds continue to gain traction, Fabian said.
Given that investors have been saying that California’s general obligation bonds have been pricing at triple-A even with double-A ratings, Fabian said that investors shouldn’t expect to get much of a discount on these bonds, even though they are rated below the state’s GOs.
California’s GOs rallied on Oct. 15 by about five basis points, the same day Moody’s handed the state the upgrade, but the market has reversed half of that gain, and right now they are spread almost exactly as they have been all summer, Fabian said.
“That’s just the market, everything is so rich," Fabian said. “It has been bouncing between being unsustainably rich and not quite unsustainably rich.”
Though it’s a new bond, Fabian said the market is generally comfortable with a partial income tax.
“If you are looking for a lot of spread on this, you might be disappointed,” Fabian said. “There might be a few basis points, but at the same time, this is 2019 and things are crazy.”
