California general obligation bonds should be rated higher than they are, according to a CreditSights report, but analysts warned the state's revenues face headwinds given its dependence on capital market gains.
California is headed to market Wednesday with a $1.2 billion competitive refunding deal. The state also has a new money GO series planned for November, but the size of that deal has yet to be announced.
"The state credit should correctly be in the high AA category," CreditSights analysts wrote in a report released Monday. "Yet, it still serves penance for fiscal sins committed in the 1990s and 2000s."
The state's GOs "should be rated higher than they are currently given the large and wealthy economy, sizable reserves, shrinking liabilities, and improved governance," said John Ceffalio, a senior municipal research analyst with CreditSights, co-author of the report.
The California Business Roundtable released a report Monday that said the state will retain its status as the fifth largest economy in the world, behind Germany. The state, which has a nominal gross domestic product of $22.9 billion, moved up a place when the U.K. economy contracted after it exited the European Union.
The state holds Aa2, AA-minus and AA ratings from Moody's Investors Service, S&P Global Ratings and Fitch Ratings, respectively. S&P has a positive outlook on the credit, while the others assigned a stable outlook.
"The spreads on California GOs have tightened ahead of the sale, which is reflected in our Market Perform rating," Ceffalio said. "Our previous rating was Outperform. At the close on Thursday, 10-year Cal GO spreads were plus-three to the municipal AAA curve."
Spread tightening this year is a function of both continued credit improvement and a lack of supply, Ceffalio said. Year-to-date, total net supply of California bonds is negative $6.4 billion, he said.
"We do expect that the new sale, with another to come next month, will push spreads a bit wider in a concession to the market," Ceffalio said.
The state priced two bond sales in October: $167.1 million of GOs on Oct. 4 and $84.4 million of revenue bonds. Proceeds from the two sales will be used by CalVet to provide home loans to veterans living in the state.
The GOs were sold with an all-in true interest cost of 4.90%, while the revenue bonds sold with all-in true interest cost of 4.96%, according to California Treasurer Fiona Ma's office. Academy Securities, Inc. and Wells Fargo were joint senior managers on both bond sales, with Amerivet Securities, Bancroft Capital and Mischler Financial Group as co-senior managers.
Though CreditSights opined the ratings should be higher, analysts said the state's credit quality has likely peaked as California's tax revenues have slowed.
Revenues for the fiscal year that began July 1 are nearly $4.8 billion below forecast, according to the monthly report released by the state's Department of Finance last week. When combined with the $2.2 billion shortfall at the end of the 2021-22 fiscal year, revenues are nearly $7 billion below the most recent revenue forecast produced by the DOF in May.
"We expect revenues to continue to disappoint due to poor equity market returns and the increasing probability of a recession, but California is well-positioned for this stress, given its large reserves and low fixed costs," Ceffalio said.
In a recession, "we see California's credit downside as well-protected by a fortress of reserves, which totaled nearly $40 billion at the close of fiscal year 2022," CreditSights analysts wrote.
