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California to test bond buyers' hunger with $4.5-billion debt deal

October 5, 2009 |  7:00 am

Are California municipal bond investors ready to say no mas to lower yields?

We may find out this week, as state Treasurer Bill Lockyer offers $4.5 billion of voter-approved general obligation bonds for sale beginning on Tuesday. It's the state's first long-term debt offering since April, and comes just two weeks after Lockyer successfully sold $8.8 billion in short-term notes.

The California muni market has been starved for supply over the last two months, with the result that market yields on long-term tax-free bonds have continued to edge lower nearly every week -- because investors have in effect been fighting over what little is available.

This has been a national story with muni bonds and with fixed-income securities in general: Long-term yields have plunged since early August as investors have rushed to lock in returns, in part reflecting doubts about the economic recovery.

The annualized tax-free yield on 10-year California general obligation bonds was about 3.5% on Friday, far below the 5.25% yield investors could have gotten in late June.

Caltreasurerseal And get this: The yield on the Bond Buyer newspaper's yield index of 20-year muni bonds nationwide slid last week to its lowest level since 1967, dropping to 3.94%, according to Bloomberg News.

Joe Lee, a muni trader at bond dealer De La Rosa & Co. in Los Angeles, said yields on California munis have dropped to levels that finally have made some potential buyers balk. "People think the market has run too fast here," he said.

California continues to have the lowest credit ratings of any state ("A" from Standard & Poor's and "Baa1" from Moody's Investors Service) because of its still-dicey budget outlook.

But thanks to federal assistance, Lockyer and other muni issuers this year have new borrowing flexibility that may work to keep yields depressed.

Though California will borrow $4.5 billion in all, the tax-free bond portion of the deal -- the traditional muni securities that individual investors want -- may total as little as $1.3 billion. The rest of the offering will be in the form of taxable bonds, including up to $2 billion of so-called Build America Bonds.

Under the Build America program, state and local governments borrowing to fund infrastructure projects can issue taxable debt that is subsidized by the federal government. That saves the borrowers on net interest costs, and provides them with new sources of investment demand: pension funds, life insurance companies and others that generally don't buy tax-free bonds.

For traditional muni investors, however, it all means a much more limited supply of tax-free bonds.

When the Los Angeles Unified School District sold about $2 billion of bonds last week to finance building and renovation projects, taxable Build America bonds comprised $1.37 billion of the deal, or more than two-thirds of the total sold.

Individual investors who are interested in the state's bond offering this week can put in orders on Tuesday and Wednesday. (You must order via a brokerage, and the minimum order is $5,000. For more information, go to Lockyer's website,

The tax-free bonds (exempt from state and federal income tax) will be split among maturities ranging from one year to 30 years. As of Friday, here's what the approximate market yields were on existing California munis: two-year, 1.2%; five-year, 2.3%; 10-year, 3.5%; 20-year, 4.4%; 30-year, 4.95%.

But there's no way to know in advance whether the state will end up paying more, or less, than those recent yields. Individual investors are at the mercy of institutional investors such as mutual funds, which will submit their bond orders on Thursday. That's when the deal will be priced and the final yields will be set.

If individual buyers don't like the final yields they can cancel their orders at that point.

So the question is whether big investors, in particular, are ready to draw a line in the sand on California muni yields -- or whether fear of missing out will again trump concern that the bond market rally of the last two months has become overdone.

-- Tom Petruno