Individual investors rush to buy California IOUs

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Individual investors on Tuesday put in orders to buy $1.84 billion of the short-term notes that California plans to issue on Thursday, a strong reception that reflects the high tax-free yields the state is offering to get the deal done.

Brokerages managing the debt sale for the state will continue to take orders from individuals on Wednesday, then invite institutional orders on Thursday. That’s when the final yields on the IOUs will be announced.

The sale of $4 billion in so-called revenue anticipation notes is critical for the state to patch its seasonal budget shortfall. Fears that California wouldn’t be able to raise the money had prompted Gov. Arnold Schwarzenegger to warn on Oct. 3 that the state might have to go to the federal government for a loan.

The debt offering is officially for $4 billion in total, but Treasurer Bill Lockyer’s office could boost the size to $5 billion if demand warrants.

At $1.84 billion on Tuesday, individual-investor orders already account for 46% of the offering if it’s capped at $4 billion.

The state is offering two separate IOUs in the deal: a seven-month note that will mature on May 20 of next year, and an eight-month note maturing on June 22.

Early Tuesday Lockyer’s office estimated that the seven-month note would pay a tax-free annualized yield of between 3.75% and 4%, and that the eight-month issue would pay between 4.25% and 4.5%.

The orders that flowed in showed most investors were reaching for the highest yield they could get: The state said orders totaled $1.51 billion for the eight-month note, nearly five times the $327 million in orders for the seven-month issue.

Because the interest on the notes is exempt from state and federal income tax, the yields are lucrative compared with what’s available on taxable bank CDs or U.S. Treasury securities. Earning a 4.25% tax-free yield, for example, would be the same as earning a 6.51% taxable yield for a California couple in the 34.7% combined federal and state tax bracket, which begins at taxable income of about $131,000.

Lockyer said the order total was an ‘excellent start’ for the offering. ‘We’re now well down the road to completing a good deal that makes sense for California taxpayers,’ he said.

But the state would be paying far more than the 2.2% yield that Massachusetts paid on a similar, though smaller, note offering last week.

If orders from individual and institutional investors are strong enough, it’s possible the state will be able to reduce the yields on the notes in the final pricing on Thursday. That has happened in some previous state debt sales. Individuals who aren’t satisfied with the final yields have the right to cancel their orders.

The minimum investment is $5,000. Investors must place orders via a brokerage (the state doesn’t take orders directly).

For more on the notes, go to Lockyer’s website, here. For a basic primer on buying California municipal bonds, go here.