State Bonds Lure Buyers Despite Budget Woes

Gov. Arnold Schwarzenegger is using words like “Armageddon” to describe the state’s worst-case budget scenario. But the view of investors seems to be a lot less gloomy at the moment.

Interest rates on California’s long-term bonds have fallen in recent weeks to their lowest levels since July. The decline stems in part from a general slide in most bond yields, including those on U.S. Treasury issues, amid expectations that the Federal Reserve won’t tighten credit anytime soon.

But some market pros say there is a growing appetite for California’s debt from investors around the country, on a bet that the state’s fiscal outlook is improving.

“We’re seeing some [buyers] invest in California for the first time in years,” said Dean Gestal, head of municipal securities trading at San Francisco-based Stone & Youngberg, a major bond dealer.

A key test of investors’ willingness to extend credit to California will come in February, when the state plans to sell as much as $2 billion in voter-authorized general obligation bonds to finance projects such as schools and parks. It would be the first such bond sale since October.

The tax-free yield on a Bloomberg News index of 20-year California general obligation bonds was at 4.90% on Friday, down from 5.12% in early December and 5.30% in mid-October. The last time the yield was this low was in early July.

Falling yields on existing bonds reflect stronger investor demand: As the price of a fixed-rate bond goes up its yield drops.

Analysts who are wary of the state’s IOUs say yields are down largely because of a rush by some investors in recent weeks to lock in any interest rates they can. Typically at the start of the year many investors have fresh cash to put to work. At the same time, the supply of new bonds usually is limited because government and corporate borrowers haven’t yet ramped up their credit demand.

Federal Reserve officials also have contributed to the downward pressure on most bond yields by strongly suggesting that they don’t feel compelled to tighten credit, with the economy still struggling to create jobs.

But even if the Fed holds steady, California bond yields could quickly shoot higher, some warn.

Schwarzenegger and his aides have said repeatedly in recent weeks that the state government’s financial position is precarious because of the accumulated budget deficit. In lobbying for the governor’s March 2 ballot propositions -- one to authorize $15 billion in deficit-plugging bonds, the other to impose a spending limit -- the administration has said the defeat of the measures could fuel new worries about California’s solvency.

In theory, that could cause investors to flee the state’s IOUs, driving interest rates up.

If voters reject the propositions, and the state’s bonds are downgraded to “junk” status by credit-rating firms, nervous investors might force the state to pay as much as two percentage points more in yield than other states to float bonds for infrastructure projects, Schwarzenegger advisor John Bohn said Friday.

For now, the penalty is much less onerous: California -- which already has the lowest credit rating of the 50 states -- is paying about a half-point more on its bonds than what states with the highest credit ratings pay. That has been enough to keep investors interested.

Dino Mallas, who manages the T. Rowe Price California Tax-Free bond fund, said he is willing to own the state’s general obligation bonds in spite of concerns over the budget.

“We feel fairly optimistic that the things that need to be accomplished will be accomplished,” Mallas said.

That also is the view of Robert Pariseau, who manages the USAA California bond fund. “When all the dust settles I think there will be higher taxes and higher fees” imposed to balance the budget, he said.

Pariseau’s fund currently owns state general obligation bonds that are backed by private insurance. But he said he was “closer to being a buyer” of higher-yielding, uninsured general obligation bonds as confidence in the state improved.

“It’s hard to see a scenario where the state’s bonds fall off a cliff from here,” he said.

Stone & Youngberg’s Gestal said the above-average yields on the state’s bonds -- exempt from federal and state income tax -- were luring hedge funds and other institutional investors hungry for decent returns.

In the past, those investors haven’t been big buyers in the state bond market, but the low U.S. interest rate environment is making California stand out, he said.

The state’s bonds “are attracting so many more players now,” Gestal said.