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Small investors forced to fight for leftovers in the muni bond market

August 21, 2009 |  7:00 am

Yield-hungry individual investors put in orders to buy $198 million of tax-free revenue bonds offered by the University of California system this week.

But most of them came up empty-handed. State Treasurer Bill Lockyer, who sold the securities for UC, had just $65.5 million of the bonds to fill individuals’ orders. The rest of the $300-million deal went to institutional investors.

The UC debt offering points up the dearth of supply of the kind of municipal bonds that individual investors traditionally have preferred: mainly shorter-term securities, maturing within 10 years.

The relative shortage of shorter-term muni debt nationwide has turned new offerings into food fights as investors try to pile in.

UC_Seal "Retail investors fighting for scraps," the Bond Buyer newspaper headlined a recent story on small investors’ plight in the muni market.

The situation is a boon for muni issuers such as UC (and for taxpayers) because it has pushed down the interest rates they need to offer to sell bonds -- in UC's case, to finance projects such as dorms and research facilities.

The flip side, of course, is that individual investors aren’t getting nearly as a good a yield as they would have even a few months ago.

When the California State University system sold revenue bonds in March, it paid a tax-free yield of 3.19% on the five-year debt in the offering. By contrast, the five-year securities in the UC sale this week will pay just 2.06%.

Many muni issuers, including UC, prefer to sell bonds maturing in 10 years or longer. Those also are the maturities favored by many institutional investors. So even though Lockyer routinely offers individuals the ability to place orders for muni bonds ahead of big investors such as mutual funds, the issues made available to individuals in the shorter terms they want often are limited in supply.

The shortage of tax-free bonds is worse this year because many issuers, including UC, are opting to sell long-term taxable bonds instead via the Obama administration’s Build America Bonds plan.

Under the program, states and other municipal issuers can choose to sell taxable bonds for public-works projects and have the federal government pick up 35% of the annual interest expense on the securities.

Selling taxable bonds means issuers can attract hefty demand from pension funds, foreigners and other investors that normally don’t buy tax-free bonds.

UC used Build America Bonds for the vast bulk of its financing this week: It sold $1.02 billion of 22-year and 34-year taxable BABs. The 34-year bonds will pay an interest rate of 5.77%. But with the 35% federal subsidy, the net interest rate to UC is just 3.75% -- far less than the system would pay on a tax-free bond of that maturity.

That's good for UC and for the BAB buyers. But as the Bond Buyer headline put it, individual investors are left fighting for the muni market's scraps.

-- Tom Petruno

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