California muni bonds rally as budget fears ebb

Strong demand for California municipal bonds in the last few weeks, amid a dearth of supply, has produced a mini-windfall for muni investors to end the summer.

The rally in state and local California muni issues also is a good sign for Treasurer Bill Lockyer, who in two weeks will try to sell up to $10.5 billion in nine-month notes to fill the state?s short-term cash needs.

Rising prices for California tax-free bonds last week boosted share prices of popular muni mutual funds to their highest levels of the year. The $13.8-billion-asset Franklin California Tax-Free Income fund, for example, closed at $6.81 a share on Friday, up 3% in less than three weeks.

Counting principal gain and interest earnings, the average California long-term muni bond fund has risen 14.8% this year, according to Morningstar. That edges the 14.6% total return of the Vanguard 500 Index stock fund, which replicates the Standard & Poor?s 500 index. (And muni bonds' tax exemption means their real returns are higher.)

California?s budget misery, its lowest-of-the-50-states credit rating and its need to issue IOUs in July and August to pay some of its bills scared off some bond investors in summer. But investors? concerns have faded since the Legislature and Gov. Arnold Schwarzenegger reached a budget deal in late-July.

Bond buyers? mood improved after the major credit-rating firms last month said they were satisfied enough with the budget agreement to keep their ratings on California?s general-obligation debt stable for now.

It also has helped that there hasn?t been much issuance of new California muni bonds, particularly in the shorter-term maturities favored by individual investors.

"Pent-up demand in California far outweighs the light supply" of new debt, said Joe Lee, a trader at De La Rosa & Co. in Los Angeles. "I guess everyone is sick of sitting on cash."

By bidding bond prices higher investors are pushing down interest yields on California munis. The rally is making JPMorgan Chase & Co.?s agreement last month to lend the state $1.5 billion for a few weeks -- at a 3% annualized interest rate -- look like a rich deal for the bank.

That loan will be repaid when Lockyer sells so-called revenue anticipation notes, or RANs, to investors the week of Sept. 21. The deal could be for as much as $10.5 billion but may be a few billion smaller depending on budget maneuvering in Sacramento.

The annualized tax-free yield on the RANs, which will mature by June 30, is expected to be between 1% and 3%. The stronger investors? appetite for California munis in general between now and Sept. 21, the lower the yield is likely to be on the RANs. The lower the yield, the better for taxpayers.

Matt Fabian, a senior analyst at research firm Municipal Market Advisors in Westport, Conn., believes investors will be eager buyers of the RANs, and figures the state will pay a yield of 2.5% or less. "Most people I talk to think it?s going to be a very strong pricing," he said.

But that could hinge on the August tax revenue data the state is expected to report later this week, Fabian said. If the numbers are weaker than anticipated, investors could quickly go back to wondering just how deep a fiscal hole California really faces.

That?s what worries George Strickland, a muni bond fund manager at Thornburg Investment Management in Santa Fe, N.M. "I think the rally is premature," he said.

-- Tom Petruno