Bonds

The secondary market has yet to react to California’s negative outlook from Moody’s Investors Service, as credit spreads have generally tracked the recent market selloff.

While Municipal Market Analytics acknowledged that California faces some economic headwinds, the firm was surprised at how quickly Moody’s revised the outlook after the governor’s May budget revisions were announced.

The systems the state put in place after the 2008 financial crash, including voter-approved taxes and a reserve fund, appear to be holding the state in good stead despite this year’s volatility, said Matt Fabian, an MMA partner.

“I think the amount of resources they have and the structural improvements should be recognized,” Fabian said Tuesday in an interview. “We were surprised at how quickly the switch to a negative outlook came, because it seemed fast for such a large and well-run state.”

Moody’s revised the outlook to negative from stable May 18 citing the state’s revenue uncertainty just six days after Gov. Gavin Newsom released his May revise.

The rating agency also affirmed the Aa2 rating on the state’s general obligation bonds, citing the state’s massive economic base and healthy budget reserves and liquidity.

The outlook change hasn’t affected secondary trading of the state’s paper. California yields have risen in recent trading, but mostly along with general market moves as the market has sold off. Though trading on California debt has generally been choppy over the past year or so.

“It’s unlikely the outlook change drives California prices cheaper or wider,” Fabian said. “If there is a generic market sell-off and California bonds cheapen during that, it would present a buying opportunity.”

Refinitiv MMD 10-year California spreads have averaged +9.3 basis points in the 10-year range for the past year, Refinitiv MMD’s Daniel Berger noted Tuesday morning. The spread hit a three-year low of +1 basis points on February 9.

Fabian noted in the MMA’s Monday Outlook that state bond spreads have held within a 0-20 basis point range over the last year to its AAA scale, but they may “be vulnerable to widening if California holders either sell or demand relative price concession to take down new primary loans.”

As the governor plans to reverse the mid-pandemic tactic of using excess receipts in lieu of borrowing, there may be more new-money borrowing than in prior years, he said.

In his May revise, Newsom announced the state’s projected deficit for fiscal year 2024 had grown by more than $9 billion to $31.5 billion as revenues came in below the January forecast. The state doesn’t plan to tap the $22.5 billion budget reserve, and will instead cut spending and shift some projects from pay-go to bonds.

The governor said when he introduced the budget in January, the state would issue $4.3 billion in bonds, rather than using cash to fund some projects.

“We had a $73 billion surplus in fiscal year 2020-21 and a $100 billion surplus in fiscal year 2021-22, so we did not need bonds, but we will be tapping bonds this year,” Newsom said in January.


The budgetary steps recommended by Newsom to reduce the deficit in his budget revisions are sustainable, plus the governor left reserves largely untouched, Fabian said.

“While the California numbers are a disappointment, a coming-to-ground on the part of state capital-gains-dependent tax revenues has been inevitable, in particular following stock market losses in 2022, equivocation in 2023,” Fabian wrote.

The state is notoriously dependent on high-net taxpayers who account for about 50% of income tax revenues, Newsom said in his May revise presentation. That dependence on capital gains also means state revenues swing up and down along with the stock market.

If the budget gap continues to widen in 2024 and the state is forced to use more one-time solutions, rather than looking to reoccurring solutions, Fabian said, he could see more justification around an outlook revision.

“The state deficit comes through uncertainty around revenues, but the state hasn’t yet seen revenues collapse, they are just projecting revenues will be hurt,” Fabian said.

MMA also thinks the state’s ratings could be a tad higher to AA or AA-plus, relative to its default risk. The state holds a AA-minus rating from S&P Global Ratings with a positive outlook and holds a AA rating from Fitch Ratings with a stable outlook.

“We tend to think states are generally underrated relative to their default risk,” Fabian said. “California is a huge state with immense taxable resources and it has a structural payment priority for its GO bonds.

Revenues are volatile, but “they have made a lot of structural improvements in their processes in last 10 years, including how they sequester money in reserves and the controls around spending,” Fabian said.

“While it’s possible the state could return to 2003-era shenanigans, it seems less likely because of the structural improvements they have made in the system,” Fabian said, referring to bygone practices of regularly issuing revenue anticipation notes and even bonding to pay for operations. That debt that has since been paid off.

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