For California muni bond market, no state budget is no problem

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A financial emergency in California?

That’s what Gov. Arnold Schwarzenegger says we now have, as the state still has no budget for the current fiscal year.

But California’s municipal bond investors haven’t been willing to play along with this “emergency” idea. Even as the budget battle has dragged on this summer, there has been no harsh penalty inflicted on the state by investors in the form of sharply higher interest rates on its bonds.

In theory, at least, if disgusted investors were to dump the state’s debt, sending market yields on the bonds soaring, they could deliver a message to Sacramento to get its act together.

Instead, just the opposite has happened: Market interest rates on California’s general obligation bonds are well below their spring highs, and on short- and intermediate-term bonds the rates have continued to plunge in recent weeks to their lowest levels in years.

Case in point: The annualized tax-free yield on the state’s five-year general obligation bonds has tumbled to about 2.1% from nearly 3% in mid-April, according to Bloomberg News data. The yield was about 4% in mid-2009.

‘No one likes these yields,’ says Joe Lee, a muni bond trader at De La Rosa & Co. in L.A. ‘But people have been sitting on cash and feel like they have no other choice.’

The rally becomes self-reinforcing: Investors who own previously issued California muni bonds have seen the value of their securities rise as market yields have fallen. That has boosted returns on California muni mutual funds this year.

The Franklin California Tax-Free Income fund, one of the biggest such funds, is up 5.4% year to date in “total return,” meaning interest earnings plus price appreciation. And because muni interest is tax-exempt, that’s equivalent to a much higher taxable return, depending on your tax bracket.

In part, California bonds are just following the national trend in muni yields. Interest rates on fixed-income securities in general have fallen across the board over the last two months as money has continued to pour into the bond market. Disgusted with the stock market and fearful of the economy, people want something that pays regular interest and feels relatively safe. Bonds fill the bill.

In the muni bond market continuing demand has collided with falling supply. New issuance of tax-free bonds nationwide fell 22% in the first half of the year from the same period of 2009, according to Matt Fabian, senior analyst at research firm Municipal Market Advisors. Many states and municipalities have curtailed new debt sales as they grapple with budget woes, Fabian notes.

The supply of tax-free bonds also has been reduced as more state and local governments (including California) issue taxable bonds under the federally subsidized Build America Bonds program.

Something else is underpinning demand for tax-free munis: expectations that federal income tax rates will rise Jan. 1, at least for the highest-income Americans, as the 2001 and 2003 tax cuts expire. If your tax rate is going up, tax-free bond yields will be more valuable.

As for California’s budget mess, Schwarzenegger on Wednesday said he ordered furloughs of state workers to conserve cash. And Controller John Chiang has warned that he might begin issuing IOUs to pay certain of the state’s bills later this month, just as he used scrip a year ago while he waited for a budget agreement.

Should muni bond investors be concerned if the state resorts to IOUs again? It would make California look even more dysfunctional to Wall Street. And the longer this budget stalemate goes on, the greater the risk of yet another downgrade in the state’s already lowest-in-the-nation credit ratings.

But Gabriel Petek, who watches California for debt-rating firm Standard & Poor’s, notes that Chiang would use IOUs specifically to make sure the state has enough cash to pay its bondholders what they’re owed while the budget vacuum persists.

‘In a perverse way it’s a sign of strength in the credit,’ Petek said.

-- Tom Petruno