* As investors brace for tax hikes, Calif. bonds in demand
* Spreads seen shrinking more, even after a year-old rally
* Bond prices discounting possible credit rating upgrade
By Jim Christie
SAN FRANCISCO, Dec 4 (Reuters) - In a sign of optimism about California's finances, the yield spread between the state's debt and top-rated municipal bonds is expected to tighten even more in coming weeks despite a year-old rally.
California's 10-year bond spread, which used to be the third widest after Puerto Rico and Illinois, has fallen sharply since January and is now closer to the level of states with higher credit ratings such as New Jersey and Michigan.
"Sitting here today, I don't see an end to it," said Matt Dalton, who runs municipal bond investment firm Belle Haven Investments in White Plains, New York. "There's just more demand than there is supply and California benefits from that."
Boosted by strong demand for municipal bonds in general, California has also benefited from more fiscal discipline by state leaders, which has led to speculation about an imminent credit rating upgrade by Standard & Poor's.
Sara Craven, a senior portfolio manager at wealth management firm Sand Hill Global Advisors in Palo Alto, California, sees the potential for the yield spread between California's debt and top-rated municipal bonds to tighten another 10 basis points over the next three months as investors brace for tax increases.
"The election is behind us and there is greater clarity," Craven said. "Munis are going to be very important and prevalent in portfolios in an environment where tax rates will be higher."
Yields on California's general obligation bonds have been shrinking fast since last month's election, when Democrats gained a supermajority in the legislature. California's yields are now closer to those on top-rated muni bonds, which are trading near historic lows.
Andy Hempeck, a principal at Creekside Partners in Lafayette, California reported an order on Tuesday for approximately $92,000 of California GOs due in 2038 yielding 1.95 percent, compared with 2.44 percent for triple-A muni bonds in that maturity.
Top-rated 30-year muni bonds in secondary trading closed on Tuesday at 2.48 percent and 10-year bonds at 1.48 percent, unchanged from Monday and up 1 basis point from their respective record lows set last week, according to Municipal Market Data.
California's 30-year bonds now pay 48 basis points additional yield than triple-A municipal bonds, down from an additional 172 basis points they offered at their recession peak in December 2009 and from 110 basis points in January.
Likewise the 10-year bonds offer 38 basis points more yield than top-rated munis - down from a recession peak of 192 in June 2009 and their peak this year of 92 in March.
CALIFORNIA DEBT VERY LIQUID
Spreads are also tightening because California's outstanding debt is prevalent in the muni market and can be used as substitute for U.S. government debt, Dalton said: "You get more yield and you have almost the same liquidity."
Demand should also be boosted by wealthy California investors who will try to benefit from the tax-exempt status of its bonds, said Craig Brothers, a strategist at Bel Air Investment Advisors in Los Angeles.
If taxes rise when Bush-era tax cuts expire at the start of 2013, well-off Californians face a double whammy with more federal taxes and higher state taxes after voters last month approved Governor Jerry Brown's tax boost.
The state income tax hikes - which affect annual income of $250,000 and above - will spur continued interest in tax-exempt income, while at the same time their revenue will bolster the state's coffers, Brothers said.
"Both of those are going in the right direction to make the spread tighter," he added.
A potential rating upgrade may also be tightening spreads, said Billy Schmohl, vice president at broker-dealer Alamo Capital in Walnut Creek.
"As long as things stay the course, I think there's the possibility we could get an upgrade in the not too distant future," Schmohl said.
Standard & Poor's Ratings Services recently said California's credit quality may improve after voters approved Brown's tax measure. California is S&P's lowest rated state at A-minus with a positive outlook.
Moody's Investors Service rates California one notch higher while holding Illinois at its lowest rating of any state, at A2.
Revenue from the tax measure, economic recovery and spending cuts imposed in recent years are expected to bring stability to the state's finances. California's Legislative Analyst's Office said that the state faces a $1.9 billion budget gap for its next fiscal year - a small shortfall compared with the past.
Brown in January projected at a deficit of more than $9 billion for the current fiscal year, which runs through next year, compared with a $25 billion deficit in the prior year.