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Hunger for yield could help California in looming debt sale

August 11, 2009 | 12:58 pm

California, which will need billions of dollars in short-term loans soon, could find itself paying a much lower interest rate on that debt than it might have feared a month ago.

Partly, that’s a function of finally having a state budget, precariously balanced though it might be.

But the state also may be a big beneficiary of investors’ hunger for decent yields on fixed-income securities, with money market mutual funds and bank savings accounts paying virtually nothing.

Cash has poured out of money market funds in recent months, and some of that wad has flowed into tax-free muni bonds, particularly issues maturing in less than five years.

"So much short-term money is pent-up" and looking for a better home, said Joe Lee, a muni bond trader at De La Rosa & Co. in Los Angeles.

Bearflag The state’s budget mess seemed to come to a head at the perfect time for investors who were growing restless to move their cash into securities paying higher returns.

Concern over the state’s ability or willingness to pay its debts helped fuel a sell-off in California muni bonds in June. That pushed the tax-free yield on five-year state general obligation bonds from about 3% in late May to just above 4% by late June.

Those higher yields didn't last: They brought buyers flocking back to the California muni market in July. The budget deal reached the week of July 21 further eased some investors’ concerns about the state’s fiscal health.

Now, the five-year general obligation bond yield is back under 3%, traders say.

The rally in California munis has been so strong that some analysts say yields now are too low on shorter-term bonds to warrant locking up money. "The value is out of California debt," said Thomas Doe, head of market research firm Municipal Market Advisors in Concord, Mass.

But yield-hungry investors should soon have another option from the state: a debt offering that will bridge the gap between near-term spending needs and future tax revenue.

California state finance officials, including Controller John Chiang and Treasurer Bill Lockyer, will be meeting this week to hash out the state’s cash flow outlook in the wake of the budget deal. Then they’ll decide on the size and structure of the debt offering.

Muni market analysts have been expecting the state to borrow up to $10 billion in either "revenue anticipation notes" (RANs) or "revenue anticipation warrants" (RAWs), or some combination of the two. RAN debt would mature before June 30 of next year; RAW debt might have a term of about two years.

In June, when the market was slamming California, some analysts thought the state might have to pay annualized tax-free yields of 5% or higher on a RAN or RAW offering to entice investors.

But given the appetite for the state’s shorter-term general obligation bonds over the last month, the question now is whether investor demand might be robust enough to allow the state to sell a RAN or RAW at substantially lower yields -- say, closer to 3%.

Muni analysts’ current guesses on RAN or RAW yields are all over the map. Some say California might still have to pay close to 5%, given the state's rock-bottom credit rating and because RANs and RAWs don’t have the same strong repayment guarantee that the state Constitution provides for general obligation debt.

Others note the dearth of opportunities to lock up money for one or two years at a decent yield. With that backdrop, even a 2% tax-free yield from California might be too attractive for investors to pass up.

-- Tom Petruno

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