State bond investors place bet on governor's budget moves.

John Flahive, who oversees $11 billion of municipal bonds for Mellon Private Wealth Management in Boston, bet on Gov. Arnold Schwarzenegger.

Flahive boosted his allocation of California state debt for eligible clients closer to the maximum 5 percent from 1 percent. Mellon's fixed-income chief figured it might be his last chance to buy the state's bonds at record yields.

Now that voters of the most-populous U.S. state have approved the bonds, Flahive expects the state's ratings to rise, borrowing costs to fall and his own holdings to gain in value.

Standard & Poor's said it may lift the state's BBB bond rating because of last week's vote. Moody's Investors Service, with a rating one evel higher than S&P at Baal, said it changed its outlook on California's credit to stable from negative.

"If they don't go crazy on spending the bond proceeds, have a good budgetary process and revenue improves," said Flahive, who bought some California bonds on Feb. 19, "it could be an A-rated credit within 20 months."

Schwarzenegger, by getting voters of the lowest-rated state to pass $15 billion of bonds, put California on a course to cut its borrowing cost. California, which once borrowed at yields 0.2 percentage points below top-rated debt, saw its cost rise to record levels after its budget deficit widened to as much as $38 billion last year.

California bond yields have fallen on anticipation that Schwarzenegger's bond plan would be approved. The debt traded last August at yields as high as 90 basis points, or nearly 1 percent, over top-rated debt, fund managers said. A basis point is 0.01 of a percentage point.

How fast

Six managers of more than $55 billion of bonds said in interviews that how fast borrowing costs fall will depend on whether the state permanently reduces its deficit.

The cost of borrowing won't "come in dramatically" because California is still rated triple-B and has its budget deficit, said Stephen Scharre, who oversees $13 billion of municipal securities at Banc of America Capital Management in Los Angeles. "All this does is take away the liquidity crisis and allow the budget to heal over time," he said.

Passage of the bond issue could tighten the spread by 15 basis points, said John Hallacy, managing director of municipal bond research at Merrill Lynch & Co. "What happens with the budget is more important, and has a lot more to do with determining future spread direction," said Hallacy.

Flahive said borrowing costs would fall if the state cuts its deficit and companies that rate bonds raise the state's ratings. "This allows them to begin to go forth with a plan and deal with their short-term problem and move forward to having a credibly balanced budget," Flahive.

'Still speculating'

Joe Deane, who manages about $7.5 billion of municipal bonds for Citigroup Asset Management in New York, said he has been avoiding California's debt. His portfolios own $4 million of the state's bonds, less than 1 percent. He still isn't sure when he will start buying the state's bonds again. Deane said he is more interested in seeing the state balance its budget than earning a spread of 70 to 90 basis points over top-rated debt.

"Until you get structure in place, you're still speculating and I'd rather not do that at the moment," said Deane. "Show me you're doing the right thing."

Investors don't expect yields to fall right away as the state sells $15 billion of new debt.

"I have a hard time seeing the spread narrowing with that supply looming," said Stephen Kelleher, who runs municipal underwriting for RBC Dain Rauscher in San Francisco.

The size of the bond sale could keep the spread to triple-A higher to attract buyers, said Deane. "If they're going to bring something with that kind of size, you're going to have be accommodating and pay some yield concessions," he said. State Treasurer Philip Angelides said that the state would probably sell only $6 billion in June.

The cost of the state's borrowing could be driven up if all $15 billion comes at once with $16.2 billion more of bonds California voters approved. Voters passed $12.3 billion of state bonds for schools and Los Angeles voters approved $3.9 billion of school bonds. Angelides said in the press conference that he probably would break the bond issues down into smaller pieces and reschedule another $2.7 billion of expected debt sales so all the state's debt doesn't hit the market at once.

"Not all would be sold in one fell swoop," said Angelides. "With this much debt there is going to be an increase in borrowing cost."

The new bonds will have a direct sales tax pledge as well as a general tax pledge, which should get it a better rating and attract more buyers to cut the state's cost, said Scharre.

The 60 to 80 basis point spread over top-rated debt California paid across all maturities Feb. 19 was lower than the 80 to 90 point spread some investors predicted before the sale, said Kelleher.

"That's a sign that demand for the bonds is still very high," said Kelleher. Passing the bond issue "will put a cap on growth of the spread," said Kelleher, although he doesn't "see it narrowing with all the new supply looming."