LOS ANGELES - California returns to market this week with a $1.3 billion general obligation issue that features keen market interest in pricing levels and the twist of longer maturities with a redemption option.
The state is emerging from a tumultuous summer that saw a fiscal 1993 budget approved two months late. California also remains gripped by a nagging recession, according to many indicators. With such challenges as a backdrop, California is entering the market Wednesday with a massive competitive sale, largely for school construction, that will test both investor appetite and pricing levels.
But despite recent turmoil, certain factors likely will work in the state's favor, market participants said Friday. For example, bond dealers and portfolio managers predicted potential strong demand from crossover buyers for maturities in the one-year to 10-year range. They said a 10-year tax exempt yield in today's market may offer close to 88% of the return on comparable U.S. Treasuries, and that relationship could be irresistible to many investors.
Furthermore, the state could benefit from its absence from the long-term market since its last GO sale in February.
"There's going to be natural demand for the issue just because of reduced supply" in recent months, noted John Haley Jr., a portfolio manager for three California bond funds at Fidelity Management & Research Co..
That demand could be tempered, however, by the knowledge that more bond sales by California agencies are in the wings, including a possible GO deal in a few weeks, some market participants said. Nevertheless, those who view the state as a strong credit may be poised to jump in if pricing levels are right.
"We see the state as a double-A credit," so yields inconsistent with that assessment may present "an opportunity," said Joseph Rosenblum, director of municipal research at Sanford C. Bernstein & Co.
Rosenblum, in a report a year ago this month, correctly predicted that the state's triple-A rating would tumble because of recurring budget problems and underlying demographic and population trends affecting state finances.
Now, Rosenblum said, he sees "some real positive points to the budget" that recently closed an $8 billion gap. In particular, he said California is starting to make progress in addressing a structural budget imbalance, and "we think that's a real positive step."
Moody's Investors Service on Friday added that the state has "made inroads toward correcting its budget imbalance problem." In a news release, Moody's confirmed its Aa rating on California's GO bonds while saying, "The budget is again expected to fall out of balance before the end of the fiscal year as a result of continued revenue weakening."
Standard & Poor's Corp. rates the GOs A-plus and Fitch Investors Service Inc. rates them AA. Fitch said in a release Friday that the credit trend for the GOs is "now uncertain," given an unclear economy and the state's unproved ability to adjust to prevailing conditions.
The preliminary official statement for Wednesday's sale alerts investors to the state's continuing economic weakness. The prospectus says, for example, that the Commission on State Finance believes conditions are closer to a "pessimistic" forecast it made in May.
Haley observed that investors in the state's notes would tend to have more concern about any cash-flow crunches. But long-term investors also "are going to have to be cautious," he said, about the state's fiscal problems in case more bad news sweeps the market.
William Reeves, portfolio manager of a tax-free California fund for the Putnam Cos., said much downside risk may be eliminated because the state's GOs are "down 40 to 50 basis point from where they used to trade" relative to other credits.
"We see this as a good A-rated credit with potential to improve," he said, adding, "We would participate at the right level" in this week's deal.
Much of the market talk about the new issue centers on the maturity structure. California traditionally sells noncallable GOs with the longest maturity being 20 years.
Bonds maturing in 20 years or less retain that noncallable feature in the upcoming deal. But the state also is including almost $350 million of principal maturing evenly in 21 to 30 years, subject to an optional redemption after 10 years.
Hal Geiogue, assistant state treasurer, said it made sense to try extending the maturities because the yield curve is extremely flat, meaning the state should not pay a much higher rate.
A market participant with extensive California experience also observed that the structure could help marketing efforts by allowing the state to avoid including so much principal in the 10-year to 16-year maturity range. That part of the curve "can be difficult to sell," whereas investors will jump at longer maturities once they entail a coupon at about 6%, the participant said.
In regard to the callable securities with maturities above 20 years, the state is "definitely going to give something up" in yield to compensate for the redemption option, said Bernie Schroer, a portfolio manager at the Franklin Group of Funds.
But, he added, "as far as we're concerned that would interest us," especially because there are doubts, given today's low interest rates, whether the bonds will ever be called.
Market participants said Friday it was premature to predict expected pricing levels for Wednesday's deal. Based on recent trading ranges, they suggested that new 20-year bonds may yield from 6.30% to 6.35%, with another five basis points tacked on as maturities near 30 years.
A trader said it might make sense, depending on this week's pricing levels, to swap out of other securities and into the state's GOs, partly "to take maximum advantage of Cals when they're hurting."
There was also discussion Friday about the possibility that underwriters might obtain bond insurance for a portion of Wednesday's issue. But some market participants questioned whether insurance makes sense, considering that Moody's did not lower the state's rating.
Two groups are expected to bid on the bonds, with Lehman Brothers running the books for one bid and Merrill Lynch & Co. leading the other.
Bank of America traditionally has filled the spot occupied by Merrill Lynch.
W. Peck Ferrin, vice president and manager of municipal underwriting at Bank of America, said Merrill Lynch has "always taken a very responsible role" in the syndicate, and it it "well deserved" for the firm to rotate as a bookrunner.