California’s budget woes could affect pricing for its fall bond slate

California’s massive size and tax structure has long given it municipal bond market protection against credit challenges like its well-known tax revenue volatility.

The state government’s strengths, providing relatively liquid paper through high volume in a specialty state with high marginal tax rates, often outweigh its credit weaknesses for investors.

But massive deficits during the past two budget cycles may be starting to have an impact.

Craig Brothers, a partner with Los Angeles-based Bel Air Investment Advisors, told The Bond Buyer that California debt comprises the “lion’s share” of his company’s assets under management, but it doesn’t buy the state’s general obligation bonds or its State Public Works Board lease revenue bonds because of the revenue volatility.

“Our view is the state has budget issues that are exacerbated as the economy weakens,” Brothers said. “The extreme reliance on the top 10% of the tax base, becomes very problematic in an economic downturn. We focus on owning revenue bonds in California.”

As Fitch Ratings puts it, “Tax revenues are dominated by personal income taxes, which are economically sensitive, particularly those related to capital gains.”

With the revenue stack dominated by higher-income taxpayers, the result is a revenue rollercoaster that amplifies both economic boom years and lean years.

At the same time the state’s income tax structure, with a top marginal rate of 13.3% for people with more than $1 million in income, turns in-state municipal bonds into an attractive tax shelter.

“I think if you are already heavy on the state of California, it’s probably not a good time to add more — because of the deficits,” said Matt Fabian, a partner at Municipal Market Analytics.

“Although it seems like the state has the ability to manage the deficits with little economic disruption,” Fabian said. “We still don’t know what next year looks like.”

Fitch maintains a stable outlook on its AA rating for California.

“We are maintaining a stable outlook on the rating and have noted that the state took positive steps towards closing a structural gap, but that some work remains in the out years to really bring spending and revenues back into alignment,” analyst Karen Krop said.

Fitch referenced California temporarily raising revenues amid its current fiscal struggles in a national report published Monday in which it said it anticipates states returning to more typical budgeting practices in 2025.

California, New Jersey and Illinois were highlighted as the only states that had raised taxes on a temporary or permanent basis during what Fitch said was a wave of significant policy tax changes this year.

California temporarily adjusted certain business tax provisions and raised its managed care organization tax.

“I think, for California, the revenue increases were part of a package that included expenditure reductions, reserve draws, and also some one-time or short-term solutions to resolve the budget gap,” Krop said.

Moody’s Ratings revised its outlook on the state to negative from stable in May 2023, citing the state’s revenue uncertainty. It has the state at Aa2.

S&P Global Ratings revised its outlook to stable from positive in December. The rating is AA-minus.

“Moody’s was quick to switch to a negative outlook,” Fabian said. “We think they went too fast, because part of what makes California better credit now than what it was 10 years ago is not only that it has better reserves, but also that it improved its budget management. It has more tools to manage deficits in a sustainable way. It’s not just higher reserve, but improved processes.”

Changes enacted during Jerry Brown’s second act as governor from 2011 to 2019 created a structure that fills state reserves in big revenue years.

Now, Fabian said, it would be harder for the state to slip back to where it was before the 2008 crash.

“The ratings are if anything too low,” he said.

Though rating changes draw bigger headlines, Fabian said outlook changes can have an impact on pricing, because they represent a change in momentum.

And beyond California, munis as a whole are likely to underperform Treasuries, especially with the Fed talking about a rate cut, he said.

“With large incremental new supply on top of revenue volatility, California could underperform more than others,” he said.

But the state does have a lot of debt coming; as of Aug. 1, it had $27 billion of authorized but unissued GO bonds, with $20 billion more on the November ballot.

California State Treasurer Fiona Ma has six more municipal bond offerings planned in fall 2024, according to the treasurer’s investor-facing website.

On Sept. 24, California will price $800 million of State Public Works Lease Revenue Refunding Bonds, following a retail order period on Sept. 23.

On the week of Sept. 29, the state will bring $750 million of variable-rate GOs.

It plans to price $100 million of GOs in an Oct. 1 competitive deal to support veteran’s programs. And then on Oct. 8, it will price $80 million of home purchase revenue bonds for the Department of Veteran Affairs.

It has another public works series coming on Oct. 16 in a competitive deal for $310 million and more GO tax exempt and taxable various purpose bonds are coming the week of Oct. 20.

Siebert Williams Shank & Co., LLC and Jefferies LLC are joint senior managers on the Public Works Board deal. Stern Brokers & Co is co-senior manager. Seventeen banks are co-managers.

The state typically sells multiple deals in the spring, then after the state budget is approved in June pushes out a second fall series of bonds.

No one from the treasurer’s office was available to comment on the upcoming deal or the fall slate.

The in-state demand for tax-advantaged investments means California bond deals have priced at yields lower than triple-A muni benchmarks.

The Trustees of the California State University sold $671 million of tax-exempt bonds on Aug. 5 with yields as much as 26 basis points below that benchmark, according to LSEG’s The Municipal Market Monitor (TM3). The 10-year came in 12 basis points under the benchmark.

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On Aug. 27, the state sold $2.6 billion of tax exempt GOs. That deal didn’t fare as well against the benchmark.

The 10-year GO priced with a 5% coupon to yield 2.93%, for a +24 basis point spread, according to TM3 by Refinitiv/LSEG.

In the state’s August 2023 GO pricing the spread on the 10-year was 13 basis points.

Since Ma took office in January 2019, the State Treasurer’s Office says it has sold $21.3 billion of refunding GOs for debt service savings that will save taxpayers $6.8 billion over the remaining life of the bonds, or $5.5 billion on a present value basis.

BofA Securities Inc. and Barclays Capital Inc. were joint senior managers of the August GOs with Ramirez & Co, serving as co-senior manager and 27 firms as co-managers.