Don't tell Sacramento, but state's bonds lure buyers again

Investors' appetite for California municipal bonds has improved noticeably in the last few days, driving down market yields on the securities.

Unfortunately, that could send exactly the wrong message to the Legislature and Gov. Arnold Schwarzenegger, who are at a stalemate in budget negotiations. If they think falling interest rates mean investors have faith in the state’s financial outlook, there may be even less incentive to strike a budget deal soon.

Market yields on the state’s general obligation bonds began to surge in late May as the budget nightmare worsened and some spooked investors bailed out, pushing down the prices of the bonds. As the price of a fixed-rate bond fall its yield rises.

The annualized tax-free yield on 10-year California bonds jumped from about 4.4% on May 22 to nearly 5.25% by the end of June, the highest level since the massive sell-off in all muni bonds during the credit-market meltdown last fall.

But renewed buying interest since July 1 has pulled the 10-year bond yield back below 5%. Bloomberg News data pegged the yield at 4.99% on Thursday. Some bond dealers were quoting yields just under 4.9%.

Market rates have pulled back on the state’s bonds across the board. The yield on five-year general obligation issues has fallen to about 3.8% from more than 4% two weeks ago.

"There are still a lot of sellers, but not as many as last week," said Joe Lee, a trader at De La Rosa & Co. in Los Angeles. That has allowed yields to come down as more individual investors have stepped into the market, he said.

Matt Fabian, senior analyst at research firm Municipal Market Advisors in Westport, Conn., recommended in late June that income-hungry clients begin to put some money into California bonds, citing their high yields.

For a couple in the 32% combined federal and state tax bracket in California (which begins at taxable income of about $94,000), a 5% tax-free muni yield is the equivalent of earning a yield of about 7.3% on a taxable investment, such as a corporate bond.

Fabian said the market has improved in part because of the turn of the calendar: Many dealers didn’t want to hold the state’s debt as of June 30 for accounting reasons, but have been willing to add to their inventories again with the start of the new quarter.

It also has helped the muni market that U.S. Treasury bond yields have tumbled in recent weeks.

Most muni market pros don't believe that California will default on its bonds, because debt repayment is mandated by the state Constitution. Still, the state's financial image is so tattered, bond yields are unlikely to drop substantially from here, says Parker Colvin, a trader at Stone & Youngberg in San Francisco.

"I think there’s definitely a limit" to the current rally, he said, with no budget deal in sight and the state issuing IOUs to pay many of its bills.

He also said that many nervous investors continue to shun California general obligation issues, and any bonds backed by property taxes, in favor of issues backed by revenue from essential services, such as water or power.

Ten-year bonds issued Thursday as part of a Culver City Wastewater deal paid a 3.95% yield -- about one full percentage point below what the state’s 10-year bonds are yielding, Colvin noted.

-- Tom Petruno

Comments

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Some bond analysts will tell people anything in order to sell their muni bonds. They like to refer to past experience of default rates and assume that it is the same now. Think again. We are in a severe recession to depression and many municipalities are on the verge of bankruptcy or will be downgraded by the rating agencies. When the bonds get downgraded and liquidity in the bonds purchased dries up and the prices of those bonds go down in value, the analyst hides in the woodwork. The investor gets to hold downgraded bonds which have declined in value. The spreads between AAA, AA, A, BBB, and below muni bonds are enormous. If you buy a California bond at A and it goes to BBB or lower its value is going to collapse dramatically. So if you have to sell the bonds for whatever reason be prepared to take a huge capital loss which you can never recover. The only choice you will have is to hold your bond to final maturity. Who wants their money locked up for 10-15-25-30 years worring about the bond for a 4.0 to 6.0 interest rate. Effectively if you buy a California muni bond ( and many other states and cities) at this time you are making a loan to that state or city. You are not really buying a security ( even though legally it is a bond). Califonia muni bonds have as much liquidity as a loan. Commercial loans have little or no liquidity. Just try to sell your muni bond and see how much spread ( the difference between where you bought the bond and where you can sell it ) you have to absorb. Some bonds have one half to one point spreads. That translates into hugh losses for the investor. Will the analyst tell you about that risk when you buy?