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Budget mess takes rising toll on state's muni bond market

June 25, 2009 |  5:00 am

While the budget battle drags on in Sacramento, more investors in the municipal bond market have already reached a consensus: They want out of California.

"There are lots of sellers" of the state’s general obligation bonds, said Bob Gore, a veteran muni trader at brokerage Crowell Weedon & Co. in Los Angeles.

That shows up in the yields being quoted on the bonds in the marketplace: A glut of sellers means buyers can demand higher returns to take bonds off the sellers’ hands. That means sellers have to drop their asking prices. (Remember: With a fixed-rate bond, the yield goes up as the price goes down.)

The annualized tax-free yield on 10-year state general obligation issues was about 5.2% on Wednesday, according to Bloomberg News data. That was up from 4.4% just a month ago and the highest since December, when the global credit crisis was fueling widespread dumping of municipal and other bonds.

Fi-markets25 Yields on muni bonds nationwide generally are up from a month ago, but not like the surge in California issues. When the state goes to borrow again, it will pay painful prices for money.

As I’ve written many times this year, California is highly unlikely to default on its bonds because debt repayment is mandated by the state Constitution -- even if that means gutting spending on essential services to make bondholders whole. Why, then, are investors selling? Some are just afraid that others will keep selling, driving bond prices even lower and further devaluing all California bond owners' portfolios.

Wall Street knows that some institutional investors, for example, might have to jettison California general obligation bonds if credit-rating firms cut their ratings on the state yet again, as they’ve warned in recent weeks that they might depending on the outcome of the budget battle.

So even as tax-free muni yields rise to seemingly attractive levels for people who still have money to invest, many potential buyers stay sidelined. "The marginal seller can drive where the market goes," said George Strickland, a muni bond fund manager at Thornburg Investment Management in Santa Fe, N.M.

Not surprisingly, the state’s mess also is making buyers scarcer for bonds of some smaller California cities and other municipalities that stand to be hurt by Sacramento’s budget-slashing.

Though the California muni market overall is holding up better than it did in last year's credit-crisis-induced panic, "There is tremendous illiquidity in the market," said Steve Kelleher, head of muni bonds at brokerage Wedbush Morgan Securities in San Francisco.

This is exactly the kind of environment that bargain-hunters ought to relish. But given what the California muni market -- and the state economy -- will be facing in terms of nightmarish headlines in the next few months, buyers don’t have to be in any rush.

-- Tom Petruno