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

July 10, 2009 |  5:30 am

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.

Fi-calmuni 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