* Illinois remains as U.S. state with lowest rating
* Bond prices already discounted upgrade
* More improvement possible
By Jim Christie
SAN FRANCISCO, Jan 31 (Reuters) - Encouraged by California's improving finances and expectations of balanced budgets, Standard & Poor's upgraded its rating on $73.1 billion of the state's general obligation bonds by one notch on Thursday.
S&P raised its rating to A from A-minus and put a stable outlook on California. It also upgraded $9.3 billion of the state's lease revenue bonds, to A-minus from BBB-plus.
The rating agency praised moves by California's leaders over the last two years to balance the state's books.
"We view the alignment between revenues and expenditures as much improved and largely a result of policymakers' heightened emphasis on fixing the state's fiscal structure in the past two budgets," S&P said in a report.
California's economy is expanding again, and voters in November approved tax increases. Both are expected to raise revenue for the state, which is the most populous in the United States with roughly 38 million residents.
The ratings upgrade comes a few weeks after Governor Jerry Brown said the state's budget deficit is gone and forecast surpluses over the next four year.
California State Treasurer Bill Lockyer welcomed the upgrade. He said lawmakers should rally behind Brown's call for restraining spending to help mend the state's finances.
Rick Ashburn, chief investment officer of Creekside Partners in Lafayette, California, which oversees about $80 million in municipal bond investments, called the upgrade long overdue.
S&P never should have rated California A-minus, Ashburn said, noting that the state's Constitution protects bondholders by making debt payment a top priority.
The upgrade leaves Illinois with the lowest rating of any U.S. state rated by S&P. The credit rating agency cut Illinois one notch to A-minus last week and said it could fall further, noting the state needs to tackle its huge unfunded pension liability.
Illinois also has the lowest state rating from Moody's Investors Service, at A2. Moody's rates California A1.
UPGRADE DISCOUNTED BY BOND PRICES
The $3.7 trillion U.S. municipal bond market, which has widely anticipated the S&P upgrade, pushed yields on California's bond lower on Thursday.
California's 10-year general obligation bonds yielded 0.29 percent more than top-rated municipal debt, compared with 0.37 percent on Wednesday and the nearly 2 percent more they offered in 2009.
Prior to the upgrade, California had the third widest yield spread after Puerto Rico and Illinois among main muni debt issuers monitored by Municipal Market Data. On Thursday, California had the ninth highest spread.
California's general obligation bonds could be on track for more positive ratings from S&P if state officials use improving revenue and hold down spending to propel the budget to surpluses, said Gabriel Petek, S&P senior director.
"Strengthening revenue performance is also quickly alleviating the state's cash-related stress and is helping eliminate its need to rely on extraordinary cash management measures," the report said. "Cash and unused borrowable resources are now approaching pre-recession levels."
Petek said S&P also is encouraged by Brown's plan to pay the state's $28 billion of internal borrowing and deferred payments used to help close budget gaps over the years.
"The backlog of deferrals means that a significant share of current year spending goes to paying for prior year expenses," S&P said. "We expect that the range of possibilities for the state's credit rating would extend higher once it is free of this inflexibility."
"We think that's a really big deal," Petek added.