California boosts yields on short-term notes amid muni market turmoil

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California was forced to raise interest rates on $10 billion in short-term debt it sold Thursday, another sign of the turmoil that has racked the municipal bond market in recent weeks.

The state, selling so-called revenue anticipation notes that will mature in May and June, set the yield at 1.50% on the May issue and 1.75% on the June issue -- up from initial estimates of 1.25% and 1.50%, respectively. The interest is exempt from federal and state income taxes.

The increase in rates shows that institutional investors such as money market funds demanded higher returns to buy the debt. Those investors placed their orders Thursday, after individual investors put in orders for $6.06 billion of the securities from Monday through Wednesday.

Institutions bought $3.25 billion of the notes. To raise the full $10 billion the state’s brokerage underwriters bought the final $750 million of notes, something they typically prefer not to do.

Investors have pulled back from buying bonds in general this month, driving yields sharply higher. The muni market has been hit particularly hard, in part reflecting a heavy supply of new issues and investors’ concerns about the strained finances of state, cities and other municipalities.

California typically sells revenue anticipation notes each year to tide it over until tax revenue arrives later in the fiscal year.

The rates on this year’s deal are 0.25 percentage point above what the state paid on similar notes in September 2009.

With the cost of money surging in the muni market, Treasurer Bill Lockyer late Wednesday reduced a planned sale of longer-term tax-free bonds set for the next few days. That offering will total $1 billion instead of $1.75 billion, he said.

At the same time, Lockyer boosted a planned sale of taxable bonds to $2.75 billion from $2 billion. Those issues, mostly in the form of federally subsidized Build America Bonds, are popular with big investors such as insurance companies and foreign institutions. With the subsidy, the state hopes to pay a lower overall interest cost than it would have to pay on tax-free bonds.

[Updated at 2:30 p.m. PST: Lockyer’s office said Thursday that the taxable-bond sale total was raised to $3.275 billion because of ‘strong investor demand indicated today.’ Bond traders said that the jump in market yields on munis finally began to draw investors in from the sidelines on Thursday. ‘We clearly have seen some stabilization’ in the market, said James Colby, a muni bond strategist at Van Eck Associates in New York.]

-- Tom Petruno