California should use its $45.7 billion surplus to pay debts early, Wall Street investors say

Morgan Stanley and Loop Capital Markets suggested to Treasurer Fiona Ma that her office consider paying off some bonds early, public records obtained by Bloomberg News show. The pitches underscore the financial strength of California given that the state’s proposed $213 billion budget is bolstered by a $45.7 billion surplus. The state’s progressive tax system rakes in more revenue when the income of its highest earners rises.

In fact, the state can generate so much revenue, it may trigger a constitutional limit on spending. Paying off some debt early can help the state get around that requirement, creating a “budget buffer” to preserve its flexibility, Loop said. Since debt service isn’t considered an expenditure under the requirement, California could pay off some general-obligation or lease revenue bonds early, the firm suggested.

“Given current budget performance and cash position, the state can also evaluate opportunities to defease bonds with cash,” Morgan Stanley said in its presentation that also listed examples of general-obligation debt that could be paid off early. The documents from both banks included more standard recommendations such as selling new debt to refund higher-cost securities.

“Select municipal issuers have begun considering using excess cash to defease outstanding bonds, aided by the influx of cash from the federal government and budget performance,” Morgan Stanley said. It did not give examples. The underwriter declined to comment further.

Meanwhile, Loop pointed to New Jersey as an example of an issuer defeasing debt. Last month, the state said it finished paying off $2.25 billion of debt early, saving $607 million over 10 years. Loop spokesperson Jorian Seay-Saunders didn’t respond to requests for comment.

“In theory, it’s great to use excess money you have to lower your recurring expenditures,” said Lisa Washburn, a managing director at research firm Municipal Market Analytics. “Since it’s one-time money, you want to make one-time investments.”

Currently, there are no plans to defease debt with cash, said California Deputy Treasurer Tim Schaefer by email. 

Of course, doing so would give California even more capacity to sell new bonds. And Governor Gavin Newsom already has proposed a way to avoid incurring new debt by paying $500 million to complete four capital projects instead of selling taxable municipal bonds. That would save the state $350 million in financing costs. 

Nevertheless, underwriters are girding for opportunities to help California take on new debt. Ma’s office has received pitches to create bond-funded programs from Goldman Sachs Group Inc. and RBC Capital Markets for home down-payment assistance and student loans, the public records show. Goldman declined to comment, and RBC didn’t provide one.

Schaefer and H.D. Palmer, a spokesperson for Newsom’s finance department, declined to comment on the underwriters’ recommendations.

“It is the nature of our business—and that of the underwriters—that a healthy exchange of ideas and creativity is important to a better understanding of the market,” Schaefer said. “Our office encourages this exchange of information and the learning that occurs as a result.”