As muni bond yields keep falling, California sets $5-billion debt sale for October

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California, which had no trouble selling $8.8 billion in short-term debt this week, next will test investors’ appetite for longer-term bonds.

The state plans to sell general obligation bonds the week of Oct. 5 to raise money for voter-approved infrastructure projects. The dollar volume hasn’t yet been set in stone, but the deal could total about $5 billion in bonds in maturities ranging from one to 30 years, a spokesman for Treasurer Bill Lockyer said.

Investors’ attitude toward California has taken a 180-degree turn since early July, when the Legislature and Gov. Arnold Schwarzenegger were battling over how to close a $24-billion budget gap (which they did, with some spending cuts and plenty of smoke and mirrors).

Concern over the state’s horrid fiscal health had helped drive up market yields on the state’s bonds in June. Back then, you could have bought a 10-year general obligation bond paying an annualized tax-free yield of 5.25%.

But those yields didn’t last, as investors quickly found them too attractive to resist, despite the state’s lousy credit rating. The California muni market began to rally in mid-July as buyers poured in -- driving bond prices up and yields down -- and that has pretty much been the story since. On Thursday, bond dealer Stone & Youngberg in San Francisco was quoting a market yield of about 3.6% on 10-year California general obligation bonds.

Five-year California bonds now are paying about 2.4%, down from 4% at the end of June.

California has benefited in part from the across-the-board drop in long-term interest rates since July, as some investors fed up with near-zero yields on short-term accounts have shifted cash to longer-term government, corporate and muni bonds.

What’s more, there has been relatively little in new tax-free muni bond issuance in the last two months, so demand has easily outstripped supply.

Even when they have sold debt, many states, cities and other muni borrowers in recent months have relied heavily on taxable, rather than tax-free bonds. Under the Obama administration’s Build America Bonds program, state and local governments can issue taxable debt that is subsidized by the federal government.

That saves the borrowers on net interest costs, but it has contributed to the dearth of supply of tax-free bonds -- and left traditional muni bond investors fighting over whatever comes to market, as I noted in this post on the University of California system’s bond sale last month.

The state’s planned general-obligation bond sale next month also will include Build America Bonds, but the amount hasn’t been decided, Lockyer’s spokesman said.

From the viewpoint of potential bond buyers, the best thing that could happen would be a sell-off in the California muni market leading up to the October bond sale, thereby pushing yields up.

But that would probably require a sell-off in the bond market overall. And so far, many yield-needy investors just aren’t in the mood to give up their bonds.

-- Tom Petruno