New Jersey and California are both attracting investors in their general obligation debt, even as their credit ratings move in opposite directions. Yield-hungry investors are buying New Jersey at wider spreads, while conservative-minded buyers are seeking out fiscally-healthier California for its improving safety.
Spreads on New Jersey GOs have widened after it was placed on Credit Watch by Standard & Poor's earlier this year, while California GOs have seen a significant spread tightening over the last year, aided by a recent upgrade also by Standard & Poor's.
"The current demand for California and New Jersey bonds highlights two different investor types found in the muni market," said Sara Kisner, a municipal research analyst at Wells Fargo Advisors.
She said a higher percentage of retail investors are likely falling into the "safety before yield" group that favors California GOs, while a higher percentage of institutional investors are in the "yield-seeker" camp for New Jersey GOs.
In addition to placing it on Credit Watch, Standard & Poor's on June 2 revised New Jersey's outlook to negative from stable, two months after downgrading the state to A-plus.
Likewise, Moody's Investors Service downgraded New Jersey to A1 from Aa3 on May 13 citing budget imbalance, revenue shortfalls, and pension problems. Fitch Ratings downgraded the Garden State to A-plus from AA-minus on May 1 because of budget strains and continued negative outlook.
"New Jersey's investors seem to be demanding somewhat higher yields as compensation for the greater risk," said David Litvack, managing director and head of tax-exempt research at U.S. Trust, Bank of America Private Wealth Management. "Its finances have become even more structurally-deficient, and the state will need to rely more on one-shots to remain solvent."
New Jersey spreads to the Municipal Market Data 10-year triple-A benchmark have widened to 39 basis points as of Aug. 8, from 33 basis points on April 9, 2013, Tom Kozlik, director and municipal credit analyst at Janney Montgomery Scott wrote in an Aug. 12 municipal market strategy report.
On Wednesday, triple-A GO bonds due in 2024 were yielding a 2.15%, according to MMD.
Given New Jersey's recent downgrade to below double-A, Kozlik said he is surprised that New Jersey GO spreads aren't wider.
The potential for a downgrade is high, in his opinion, given the need for significant changes to spending patterns and improvements in structural balance two elements which are "not easily repairable," Kozlik said.
"In order to balance the budget they rely on one-time fixes and waiting to raise revenues and cut spending will make it much more difficult to do it in a year or two or three," he said in an interview.
While he said California has shown marked fiscal and budgetary improvement in recent years, there is a stalled effort to achieve the same in New Jersey.
"Any steps in N.J. that need to be taken are being put off" to the detriment of its credit quality, he said.
"I feel safe saying N.J.'s credit rating will be downgraded before it will be upgraded."
The fiscal stress is presenting opportunities for many investors, Kisner of Wells Fargo said.
"I think there are those who are attempting to identify strong local New Jersey municipality debt that may have seen an uptick in yield because of their guilt by association to the state of New Jersey," she said.
Similarly, some investors are likely to be looking at bonds secured by state of New Jersey enhancement programs "that have solid underlying credits that have experienced ratings and pricing decline due to the state wrap of the debt," Kisner said.
Once upon a time, New Jersey and California both had initial ratings of AAA from Standard & Poor's New Jersey on Feb. 2, 1961 and California on May 3, 1968.
While they have less in common now in terms of credit characteristics, they are still both among states with the highest marginal individual income tax rates for top wage earners. California's top bracket of 12.30% is the highest in the country, while New Jersey's wealthiest residents are subject to its highest 8.97% bracket, according to the Federation of Tax Administrators.
While both states have had decades of credit challenges, California has recently distinguished itself for its sharp economic recovery of late, analysts said.
California was upgraded to Aa3 from A1 on June 25 by Moody's, citing improved governance and better finances. Standard & Poor's affirmed its A rating and revised the outlook to positive on Jan. 14, while Fitch currently maintains a stable outlook on the debt, having last upgraded its rating to A from A-minus on Aug. 5, 2013, citing ongoing economic and revenue recovery.
"Investors are aware of the improved credit situation in California, which is a notable reversal from the market's perception just a few years ago," said Marie Autphenne, director of fixed income research and strategy at Stifel, Nicolaus & Co.
Litvack of U.S. Trust said California's finances have become more balanced in the near-to-intermediate term, which has "driven down its borrowing costs, as investors seem more willing to buy the state's bonds at a lower risk premium."
California GO spreads to the MMD benchmark have narrowed to 23 basis points as of Aug. 8 from 38 basis points on April 9, 2013, according to the MMD spread data in Kozlik's report. "Bond market investors are responding to the positive changes and trends in California," he said, citing better overall governance as a key component of that recovery.
The swift and substantial spread tightening underscores the state's fiscal diligence, Kozlik added.
"A couple of years ago it seemed California was ready to fall in the ocean, but they've really tightened their belts and really staged a comeback," Kozlik said. "California's fiscal recovery is something that didn't just happen last year or the year before it's been a multi-year focus for policy makers."
Besides its recovering credit quality, tight supply is helping California's debt, Autphenne said.
"The muni market, on the whole, is shrinking as bonds maturing and being refunded is eclipsing new-money offerings," she said. The decreased supply is particularly notable in California, she said, where through the first half of 2014 the state issued about a quarter of 2013's volume.
Low overall yields and higher income tax rates were also major drivers of California GO demand this year, Autphenne said.
"As California paper offered incremental yield compared to the majority of other states, the bid was strong for the bonds, which drove spreads tighter on the year," Autphenne said. "The upgrade nearly two months ago certainly drove spreads tighter, but the momentum was there."
Christine Albano is the investing reporter for The Bond Buyer.
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