California cuts bond sale over prison legal battle

California today pared back its last big tax-free bond sale of 2009, citing legal questions about funding for a prison project.

Treasurer Bill Lockyer sold $743 million in lease revenue bonds for the state Public Works Board instead of the $1.34 billion that had been planned.

The deal was slashed in size because funding was dropped for a new death-row-inmate complex at San Quentin prison. The fate of that complex is in limbo because of an ongoing legal battle between the Legislature and Gov. Arnold Schwarzenegger over certain budget items that he has vetoed.

"Legal questions arose Wednesday about whether the San Quentin facility could be funded with the bonds," said Tom Dresslar, Lockyer’s spokesman. "The state did not have enough time to address those issues and decided to drop the project from the sale."

The smaller deal size allowed the state to slightly trim the interest rates on some of the bonds. For example, the Series I bonds maturing in 10 years will pay a tax-free annualized yield of 5.10%, a sliver less than the 5.12% the state had preliminarily set.

It helped the state that yield-hungry individual investors put in orders for $447 million of the bonds. That was 61% of the final total sold. A hefty number of individual-investor orders gives the state more leeway in negotiating the final interest rates on its bonds with institutional investors.

The state now has borrowed more than $21 billion since late September via short- and long-term debt for budget-related reasons and to finance voter-approved infrastructure projects. That supply glut has helped to push up tax-free muni bond yields across the board as investors have demanded higher returns to absorb all of the debt.

Fundamentally, tax-free munis remain appealing compared with taxable bonds, as I noted in this earlier post. The jump in yields over the last six weeks should reinforce that appeal.

The state’s borrowing binge is nearly over for the year, which could put downward pressure on California muni yields in the near term.  Lockyer has just one more sale of tax-free bonds planned for 2009: a $200-million issue for the University of California on Dec. 3.

-- Tom Petruno

Photo credit: Ben Margot / Associated Press

Despite fiscal woes, muni bonds' appeal stays strong

The good news in the sell-off that has clipped California tax-free municipal bond prices over the last six weeks is that the market now should be harder to shock.

So for muni investors, the report Wednesday that Sacramento already may be facing a $21-billion budget gap over the current and next fiscal years was more a firecracker than a bomb.

After rallying sharply in August and September, the California muni market has given back some of those gains since early October. Amid a flood of new bond sales by the state investors have demanded higher yields, which in turn has pushed prices of existing bonds down.

California is back in the market this week with a $1.34-billion revenue bond offering from the Public Works Board to finance infrastructure projects. Yields on those bonds will be set today.

All in all, though, the damage to the market from the supply glut has been relatively modest, at least for muni mutual fund investors who have the benefit of wide diversification. Case in point: The per-share net asset value of the Franklin California Tax-Free Income fund, which holds $14.2 billion of state and local debt, was $6.90 on Wednesday, a drop of 4% from the 52-week high of $7.19 on Oct. 5.

That’s unfortunate for anyone who bought near the high, but year-to-date the fund’s total return (share price gain plus interest earned) still is a hefty 15.6%. And that’s even better than it looks, given that the interest earned is exempt from state and federal income tax.

The muni market nationwide has been suffering a bout of indigestion since September, driving yields higher. But nationally and in California the market has been stabilizing over the last week or so.

Despite the dire fiscal outlooks for many state and local governments, there are three main reasons to believe that the muni market is unlikely to fall off a cliff from here and wipe out all of its recovery from the worst of the credit crunch:

--- Big investors just don’t buy the idea that actual defaults by muni issuers in 2010 will match the doomsday predictions that are out there.

"There is going to be a lot of ‘headline’ risk in the market over the next 12 to 18 months," said Chris Sperry, co-manager of the Franklin California fund. But local governments of any size know, he said, that the decision to default would make it impossible to get the basic credit they need to function. The market clearly believes that the vast majority of politicians will get out the cleaver and hack expenses further, not bond payments.

--- Muni yields still are historically high versus yields on taxable bonds. A 10-year California state general obligation bond now yields about 4.55% tax-free, compared with 3.36% for a 10-year U.S. Treasury note that is federally taxable. Muni bond yields normally are below Treasury yields.

"In order for muni yields to get a whole lot [higher] you’re going to have to see the Treasury market sell off," said John Carbone, manager of the Vanguard California Long-Term Tax-Exempt bond fund. That could happen, of course, but it probably would require the backdrop of a robust economic recovery or an inflation surge -- neither of which seems likely in the near term.

--- Many muni investors figure that tax rates at the federal, state and local levels can only go up as governments struggle to close deficits. That would boost munis’ appeal for yield-hungry investors. "Munis are going to become more attractive from a pure income standpoint," Sperry said.

Yes, he’s talking his book. But raise your hand if you think taxes are more likely to go down than up.

-- Tom Petruno

New York governor sees risk of California bond default

Besides understanding his own state’s finances, New York Gov. David Paterson apparently has an excellent grasp of California’s fiscal situation.

So much so, in fact, that Paterson feels confident speculating publicly about the probability of California eventually defaulting on its municipal bond debt.

In a Bloomberg Radio interview on Thursday, Paterson described his plans for dealing with New York’s financial woes, and why it was important to avoid budget "gimmicks which grind up your credit rating."

New York still has an "AA" credit rating from Standard & Poor’s, compared with California’s "A" rating, which is the lowest of any state.

From there the governor, a Democrat, segued into California’s plight as he sees it:

"Now many of the legislatures don’t understand what a downgrading in a credit rating is eventually going to do. They need to go spend a few weeks in California, it might be a good investment for us to send them there because California is in a state which, I don’t know, in spite of the valiant efforts of their governor, I don’t know that California can remain in a place where they don’t inevitably go into default."

Did Paterson really mean to suggest that the largest state in the Union will stiff the investors who own tens of billions of dollars of its bonds?

A spokesman said Thursday that "Gov. Paterson was simply expressing the fact that states face a variety of financial risks in the current economic and revenue environment. He did not say California will go into default."

But what do you suppose New Yorkers’ reaction would be if Gov. Arnold Schwarzenegger were to opine publicly that "I don’t know that New York can remain in a place where they don’t inevitably go into default"?

For the record, the California Constitution mandates that state tax revenue must go first to pay education costs, and second to repay general-obligation bond debt. All other expenses are subordinate to those two.

Tom Dresslar, a spokesman for California State Treasurer Bill Lockyer, said the treasurer would be "happy to have not just the legislature of New York but also the governor come out to California so we can show how we have a perfect record of paying investors in full and on time, and how we will maintain that spotless record."

Plus, we have many empty hotels that would love the business of some free-spending New York pols.

-- Tom Petruno

Photo: New York Gov. David Paterson. Credit: Tim Roske / Associated Press

California debt binge shakes up muni bond market

The municipal bond market’s message to California: Enough with the borrowing already!

Over the last seven weeks the state has sold more than $21 billion of short- and long-term debt for budget-related reasons and to finance voter-approved infrastructure projects.

That flood -- in a period when muni bond yields nationwide already were rebounding after diving in summer -- has helped to boost yields more than they might otherwise have risen, some analysts assert.

"Yields are higher because California has so much paper in the market," said Matt Fabian, who tracks muni bond trends at Municipal Market Advisors in Westport, Conn.

The state has been its own worst enemy: Its borrowing costs have risen with each bond deal, which means taxpayers will bear a bigger hit to service the debt over time.

Rising market yields also have the effect of devaluing older fixed-rate muni bonds. If you own a California muni-bond mutual fund, chances are its share price has been sliding since the end of September as the  market has suffered indigestion from the supply of new bonds.

In California’s latest offering -- a sale Tuesday of nearly $1.9 billion of bonds maturing in June 2013 -- the state had to pony up for a 4% annualized tax-free yield to lure investors to the deal.

Less than two weeks ago the state paid a yield of 2.48% on a bond with a similar maturity.

Investors’ ability to squeeze 4% out of the state in this week’s deal "is an expression of saturation of the market" by California, said George Strickland, a muni bond fund manager at Thornburg Investment Management in Santa Fe, N.M.

Demand for the bonds sold Tuesday also may have suffered because the deal stemmed from one of the gimmicks concocted by the Legislature and Gov. Arnold Schwarzenegger in July to close the state’s huge budget deficit: The proceeds will repay local governments for the $2 billion in property tax revenue that the state is borrowing from them to plug the budget gap.

The bonds become part of the state’s overall debt burden, but they’re a step below so-called general obligation issues, which have an iron-clad repayment guarantee in the state Constitution.

Treasurer Bill Lockyer obviously knows that he has dumped a lot of debt on the market this autumn. He didn’t have much choice, given the budget fixes ordered by the Legislature, and given the backlog of infrastructure bonds California has to sell.

The state’s borrowing plans had been put on hold for much of this year because of the deepening budget crisis. "We had a lot of work to do to get our financing program back on track" this fall, said Tom Dresslar, Lockyer’s spokesman.

Of course, for investors with money to put to work, rising muni yields are welcome.

Ken Naehu, who manages bond investments at Bel Air Investment Advisors in L.A., believes the state’s budget woes are far from over, which Schwarzenegger acknowledged Tuesday. Still, a 4% tax-free yield on a bond maturing in less than four years was too good an opportunity to pass up, he said.

"We gave them a large order," Naehu said.

-- Tom Petruno

California forced to boost yield on bond sale to lure buyers

California has stumbled badly in its latest foray into the municipal bond market -- a sign that investors are overloaded with the state’s debt.

Borrowing $1.9 billion Tuesday via bonds that mature in June 2013, the state was forced to pay a 4% annualized tax-free yield to lure investors to the deal.

Just last Friday the brokerages underwriting the deal, led by Goldman Sachs, had estimated that the bonds could be sold at a yield of 3%.

Individual investors put in orders for $621 million of the securities, or about 33% of the total. But that wasn’t enough to give the state much leverage with the institutional investors whose demands determined the final yield on the debt.

The bonds were issued by the California Statewide Communities Development Authority, but it’s the state itself that’s on the hook. The proceeds will repay cities and counties for the $2 billion in property tax revenue that the state is borrowing from them -- some would say, stealing from them -- under terms of the budget deal the Legislature and Gov. Arnold Schwarzenegger reached in July.

California has borrowed heavily in recent months for budget-related reasons and to fund long-term infrastructure projects, and Treasurer Bill Lockyer has been selling into a market that has demanded ever-higher yields on Golden State debt.

That’s good for investors, but taxpayers will pay the price.

-- Tom Petruno

Frequent borrower California is back with another bond sale

California, which has borrowed $16.4 billion via short- and long-term bonds since Sept. 23, this week comes back to the well once more despite the jump in market interest rates over the last month.

The state plans to borrow $2.25 billion by selling long-term general obligation bonds in the next two days, mostly aiming at institutional investors. It’s expected to be the last general-obligation bond sale this year.

The debt will be issued in three parts:

--- On Tuesday, the state’s brokerage underwriters will take orders from individuals for $100 million of 25-year bonds. The state has set a preliminary tax-free annualized yield of 5.5% on the securities.

--- On Wednesday, institutional investors will be offered what’s left of the 25-year bonds plus a total of $1.4 billion of tax-free securities maturing in either 26 or 30 years. Longer-term municipal bonds typically are purchased by big investors; individuals usually prefer to stick with shorter-term securities.

--- Unexpectedly, Treasurer Bill Lockyer also scheduled for Tuesday a sale of $750 million of taxable bonds under the so-called Build America Bonds program. Lockyer spokesman Tom Dresslar said the 30-year offering was spurred by an "inquiry" from an unnamed investor. Other institutional investors will be invited to join in the bidding for the bonds, he said.

Build America Bonds are subsidized by the federal government, which commits to making direct payments to state and local issuers to offset 35% of their interest cost on the bonds.

California sold $1.75 billion of 30-year Build America Bonds at a taxable yield of 7.23% on Oct. 8. The investor behind the "inquiry" about another such deal may be figuring to get at least that level of yield.

This week’s debt offerings will help Lockyer whittle down the backlog of bonds California voters have approved for infrastructure projects such as schools and water facilities in recent years. The backlog, now about $60 billion, also was reduced with the sale of $4.14 billion of general obligation bonds on Oct. 8.

But the lion’s share of the state’s recent $16.4-billion in borrowing isn’t funding infrastructure projects. The $8.8 billion of short-term debt issued on Sept. 23, for example, provided cash for state operations until tax revenue rolls in later in this fiscal year.

A sale of $3.5 billion of bonds last week refinanced a portion of the state’s so-called economic recovery bonds, first issued in 2004 to plug that year’s accumulated budget deficit.

-- Tom Petruno

Photo: California Treasurer Bill Lockyer

Investors turn out for California muni bond sale -- for a price

California wrapped up a sale of $3.5-billion in tax-free municipal bonds on Thursday, and was able to trim yields slightly from initial expectations as investors bid aggressively for the debt.

Still, taxpayers will foot significantly higher interest costs than they did on the state’s last general-obligation bond offering, earlier this month.

Muni bond yields nationwide tumbled from July through September. But yields got so low by late September that investors suddenly went on a buyer’s strike. As a spate of new bond offerings hit the market early in October the issuers were forced either to jack up yields or pare their deals.

California got caught in that market push-back on Oct. 8 as it tried to sell $4.5 billion in bonds, including $1.3 billion in tax-free issues. The state had to boost yields to move the bonds.

In this week’s sale -- a refinancing of the state’s so-called economic recovery bonds, first issued in 2004 to plug that year’s accumulated budget deficit -- Treasurer Bill Lockyer had to agree to even higher yields than the state paid on the Oct. 8 deal.

For example, the 13-year bond in this week’s deal will pay an annualized tax-free yield of 4.85%, compared with the 4.47% yield on the 13-year issue in the previous bond sale. Higher interest rates mean servicing the debt takes a bigger chunk of the state budget.

But it could have been worse: Lockyer said the healthy investor demand, particularly from individuals, allowed the state to trim yields from the initial estimates on Tuesday. The state had expected to pay as much as 5% on the 13-year bond, for instance.

The state got $2.49 billion in orders from individual investors for this week’s $3.5-billion sale. Institutional investors bought what individuals didn’t take. Interest earned on the bonds is exempt from state and federal income taxes for California residents.

The state will be back in the market next week with a sale of $1.5 billion in tax-free bonds to finance infrastructure projects. Those bonds are expected to be sold only in long-term maturities. The shortest-term bond in that deal may be for 23 years.

Here are the final tax-free annualized yields on this week’s $3.5-billion bond sale:

Maturity    Yield

2013............2.48%

2014............3.01%

2015............3.52%

2016............3.93%

2017............4.17%

2018............4.40%

2019............4.54%

2020............4.65%

2021............4.69%

2022............4.85%

-- Tom Petruno

With yields up, California muni bond sale sees strong demand

The steep rebound in California municipal bond yields since the start of the month is bringing individual investors back to the market in a big way.

The state’s latest bond sale -- an offering of $3.5 billion in tax-free "economic recovery bonds" -- attracted $1.7 billion in orders from individual buyers by midday today, according to Treasurer Bill Lockyer’s office.

That’s far better than the state fared earlier this month, when it offered $1.3 billion of tax-free general-obligation bonds for sale and got just $428 million in individual-investor orders over two days.

The difference this time: significantly higher yields. For example, the preliminary annualized yield offered on the 13-year bond in this week’s deal is 5%, compared with the 4.47% the state paid on a 13-year bond in the sale Oct. 8.

Interest on the bonds is exempt from state and federal income tax for California residents.

"At these [yields] retail investors are back in," said Parker Colvin, a bond trader at Stone & Youngberg in San Francisco.

The so-called economic recovery bonds for sale this week will refinance previously issued ERBs. That was the debt that voters authorized in 2004 to bail the state out of that year’s budget mess.

The ERBs are backed not only by the state’s full faith and credit, like all general-obligation bonds, but also by a dedicated portion of sales tax revenue. Because of the specific tax backing, the bonds have slightly higher credit ratings than the state’s general-obligation bond ratings.

Standard & Poor’s, for example, rates the new ERBs "A-plus," compared with its "A" rating on the state’s general-obligation debt.

The state’s brokerage underwriters are taking orders for the bonds from individual investors today and Wednesday, and will take institutional orders Thursday. That’s when the final yields will be set.

Based on the demand so far, the state could end up paying lower yields than the preliminary rates it has quoted to investors. I’m hearing that the bonds maturing between 2013 and 2019 already are sold out. That would leave just the 13-year issue. [UPDATE at 4:30 p.m.: The state said it still had bonds to sell in the 2019 and 2022 maturities.]

California will be back in the market next week with a sale of $1.5 billion in general-obligation bonds to finance infrastructure projects, but those bonds are expected to be sold only in long-term maturities. The shortest-term bond in that deal may be for 23 years.

Typically, individual investors are reluctant to buy bonds maturing that far out. Those bonds usually are purchased by big investors such as mutual funds.

Here are the preliminary tax-free yields that were quoted today on the ERB deal (again, note that the final yields could be lower):

Maturity    Yield

2013.........2.55%

2014.........3.08%

2015.........3.59%

2016.........4.00%

2017.........4.30%

2019.........4.65%

2022.........5.00%

-- Tom Petruno

Battered muni bond market stabilizes, but test looms

The municipal bond market has stabilized in recent days after a steep, two-week sell-off. A heavy supply of new bonds for sale nationwide this week will show whether tax-free yields have reached levels high enough to lure investors back.

Cash poured into muni bonds in August and September as many investors rushed to lock in yields, fed up with near-zero returns on money market mutual funds and other short-term accounts.

But the strong demand for bonds pushed down interest rates on the securities (as bond prices rise, their yields fall). The annualized tax-free yield on 10-year California state general obligation bonds plunged from 5.25% in late June to less than 4% by early October.

Then the muni market hit a wall, as buyers essentially went on strike. That wreaked havoc with California’s attempt to sell $4.5 billion of new bonds the week of Oct. 5. The state was forced to boost yields sharply to get the deal done.

The sell-off in munis nationwide continued through late last week, pushing bond prices down and yields up. The share price of the Vanguard California Long-Term Tax-Exempt muni bond mutual fund slumped from a 52-week high of $11.39 on Oct. 5 to $11.12 by last Thursday, a loss of 2.4% -- a rude jolt for investors who had forgotten that it was possible to lose money in bonds.

But the fund’s share price has held at $11.12 the last two days, indicating that the selling wave has abated.

"There’s more investor interest with yields up," said Parker Colvin, a muni bond trader at Stone & Youngberg in San Francisco.

The yield on 10-year California general obligation bonds has rebounded to about 4.45%, he said.

But the muni market nationwide will face a glut of new bonds this week, testing whether yields can hold at current levels or whether issuers will have to pay more to attract buyers.

State and local governments including Minnesota, Maryland and Cook County, Ill., will try to sell about $11.3 billion in muni issues this week, the most for any week since June, according to Bloomberg News data. The California Public Works Board will be in the market with an $800-million offering of lease revenue bonds. That sale starts today.

-- Tom Petruno

Stocks on shakier ground as indexes diverge and bond market chokes

A victory celebration isn’t much fun if you’re there all alone.

The Dow Jones industrial average closed at a new 2009 high on Friday, but without the company of any other major U.S. market index.

It'll be a bad sign for the seven-month-old rally if the other indexes can’t make their own new highs next week.

The Dow rose 78.07 points, or 0.8%, to 9,864.94 on Friday, surpassing the previous 2009 closing peak of 9,829.87 reached on Sept. 22. The index now is up 12.4% for the year and 51% from its 12-year low in early March.

Friday, by the way, was the two-year anniversary of the last bull market's peak.

The blue-chip Dow leading the way, without broader indexes staying with it, is akin to the battlefield scene of a general advancing to the top of the hill -- only to find his troops far behind. Good luck keeping that hill, general.

Still, the broader market also climbed Friday, and most other indexes are within easy striking distance of this year’s highs, which most also reached on Sept. 22. The market went into only a modest swoon after that, still defying the bears who say it’s way overdue for a sharp pullback.

The Standard & Poor’s 500 added 6.01 points, or 0.6%, to 1,071.49 on Friday, just below the Sept. 22 close of 1,071.66.

The New York Stock Exchange composite inched up 0.4% to 7,015.54, which left it within 0.5% of its Sept. 22 close.

Among small-stock indexes, the Russell 2,000, which rose 1.2% to 614.92, will need to gain another 1% or so to take out the Sept. 22 high.

In June, divergences among the major indexes signaled the top of the spring rally. The NYSE composite, for example, peaked on June 2. The Russell 2,000 topped out on June 4. The Dow was the last to hit a new rally high, reaching 8,799.26 on June 12. After that the market pulled back through July 10, with the Dow losing 7.4% in all, before buyers rushed back into the market beginning in mid-July.

Second-quarter earnings reports fueled the summer rally, and the bulls are betting that third-quarter reports will power the market in the next few weeks.

Stocks could face one other big hurdle: a back-up in interest rates.

The bond market was hit by a selling wave late this week as the steep drop in yields in recent months finally triggered a buyers' strike. Momentum traders who've been riding the bond rally quickly bolted for the door. They got an extra push courtesy of more warnings by Federal Reserve policymakers that short-term interest rates will, some day, rise from zero.

The 10-year Treasury note yield ended Friday at 3.38%, up from 3.25% on Thursday and 3.18% on Wednesday.

Yields also jumped in the California municipal bond market this week after the state was forced to boost rates on an offering of new tax-free debt to get the deal done.

Rising market yields push down the value of older bonds, which is reflected in falling share prices of bond mutual funds. The share price of the Vanguard California Long-Term Tax Exempt bond fund, which hit a 52-week high of $11.39 on Monday, had fallen 1.1% to $11.26 by Friday.

That's not a big loss compared with what the stock market might suffer in a week. Still, for bond investors who've been watching the value of their holdings rise almost non-stop since July as cash has poured into the market, this week was a rude reminder that it's possible to lose money in bonds, too.

-- Tom Petruno

Photo: On the NYSE floor on Friday. Credit: Mario Tama / Getty Images