If you told me ten years ago, or even five for that matter, that one of the biggest turnaround stories in US Public Finance was going to be the State of California, I would have declared you insane. But my words seem awfully tasty as the Golden State is relishing in its latest positive press from the municipal community; this time an upgrade from Standard and Poor’s. The move takes the rating of State’s general obligation debt from A+ to AA-. In the broader sense, this upgrade means more market confidence in the State and can also translate to lower borrowing costs as investors demand less credit spread to become holders of the bonds. For instance, between last week and this week, the State saw a compression of spreads throughout the yield curve on its debt. Following the upgrade, the California BVAL Curve decreased 9 basis points in the 10 year portion of the curve. This move seemed to track closely to the movement of AAA benchmark muni’s. More of note, the California CDS (credit default swap) curve decreased almost 30bps in that same 10 year spot. This demonstrates the decreased cost to insure a set notional amount of California’s debt from default.
A Brief History of the State’s Bond Ratings
Looking at a history of the State’s bond ratings, California bottomed out at BBB, or just above speculative grade in 2003. This move by Standard and Poor’s, brings the state debt to the highest levels in over ten years—and marks the most recent nod by a third party rating agency. While the State officials have generated positive headlines in recent years by generating budget surpluses and building a rainy day fund, the last tangible move in ratings came from Moody’s Investor Service in June of 2014, when the State general obligation debt was upgraded from A1 to Aa3.
Why the Upgrade?
According to Standard & Poor’s the upgrade was due in part to the State being able to enact their 2015-2016 budget, which is pretty much in line with Governor Brown’s proposal. The final budget would leave the State with budget reserves of over $4.5 billion and additionally is able to pay down almost $1.85 billion of existing debt obligations. The ability of the State to deleverage itself while at the same time building its Rainy Day Fund and reinstating payments to schools are all credit positives. California has revenues that are economically sensitive and has been very fortunate to be in a position to take advantage of the recovering economy.
Meaningful Pension Reform
On the pension front, while California has one of the highest Adjust Net Pension Liabilities, what separates the State from Illinois per se, is the ability to pass meaningful pension reform. In 2010, the State raised employer contributions and in 2012, California lowered defined benefit formulas, with higher retirement ages and lowered investment return assumption rates. At the end of the day, California is solely responsible for over 13% of US Gross Domestic Product. The economy is larger than that of many sovereign nations.
