Small investors shun California’s tax-free bonds
When California offered tax-free bonds for sale in recent years, the state could always count on robust demand from yield-hungry individual investors.
Suddenly, many of those investors seem to be on strike.
This week, individual investors put in orders for a modest 22% of the state’s offering of $1.8 billion in tax-free bonds to finance infrastructure projects. By contrast, those buyers had snapped up 28% of the state’s previous debt sale, in September. And in November they sought nearly 80% of the bonds California offered for sale.
The state still was able to complete this week’s sale because institutional investors, such as mutual funds, stepped up to buy what individuals left on the table.
But the relative dearth of orders from small investors is costing California taxpayers: With big investors pressing for higher returns, Treasurer Bill Lockyer was forced to boost interest rates to get the deal done Wednesday.
The five-year bonds in the sale, for example, will pay an annualized tax-free rate of 2.28%, up from the 2.10% the state had forecast Monday and up from the 1.61% rate it paid on five-year debt in September.
Some muni market analysts say individual investors are simply balking at what they see as paltry yields on the state’s general-obligation bonds, as the Federal Reserve has tried to put more downward pressure on all interest rates to help the economy.
Marilyn Cohen, head of money manager Envision Capital Management in Los Angeles, said muni yields amount to “peanuts” in the eyes of small investors, even though the interest on the bonds is exempt from state and federal income taxes, which boosts their return relative to taxable bonds.
Low yields are much more of an issue than concerns about the state’s finances, many experts say.
Although California’s credit rating is the lowest of the 50 states because of its ongoing budget woes, that has been the case for years. And the budget agreement reached between the Legislature and Gov. Jerry Brown last summer was aimed at calming investors’ doubts about California’s creditworthiness, by requiring automatic spending cuts if tax revenue comes up short.
“The one thing everybody is saying is that this has nothing to do with California’s credit perception,” said Tom Dresslar, a spokesman for Lockyer in Sacramento.
That view is echoed by bond traders and financial advisors who deal with individual investors, whom the industry refers to as retail buyers. “I don’t think retail has lost confidence in the state of California,” said Kelly Wine, executive vice president at bond trading firm RH Investment Corp. in Encino.
For the $3-trillion muni bond market overall, however, another bout of gut-wrenching volatility over the last year has shaken investors’ confidence about putting new money to work.
The muni market was hit by a vicious sell-off last winter fueled by worries about state and local government finances in general. That was when star Wall Street banking analyst Meredith Whitney made her now-infamous forecast of a wave of “hundreds of billions of dollars” in muni bond defaults beginning in 2011.
Bond prices plummeted from November to mid-January, sending market yields soaring. Since then, muni bonds have recovered most of their price declines, as the predicted wave of bond defaults never materialized and as many muni issuers have scaled back borrowing.
Despite some high-profile fiscal disasters, such as the bankruptcy filing by the city of Harrisburg, Pa., last week, most state and local governments have continued to pay their creditors in full. Nationwide, just 42 muni issues worth $949 million defaulted in the first three quarters of this year, down from 79 issues worth $2.9 billion in the same period of 2010, according to Income Securities Advisors Inc. in Miami Lakes, Fla.
Still, the market’s volatility has left investors wary.
A good measure of that: Investors in muni-bond mutual funds pulled a net $23 billion from the funds in the first nine months of this year, or about 5% of total assets, even as fund share prices have continued to rebound.
Vincent Cutarelli, a 61-year-old Laguna Niguel investor, has owned a muni bond fund for the last decade. He said he stayed put through the gyrations of the last few years, but the swings in his fund’s share price have worried him.
“Prior to 2008 the fund was very stable,” Cutarelli said. “The roller-coaster rides since then have been a concern.”
Although he has considered buying individual California bonds, he said he has put off making new investments for the time being.
More investors might be able to stomach a volatile investment that pays a high return. But with muni bond yields so low, many potential buyers don’t believe the securities are worth the effort, financial advisors such as Cohen say.
Muni yields have been pulled down this year in part by the steep drop in U.S. Treasury bond yields, which are the benchmark for other interest rates.
With California offering a tax-free yield of 2.28% on the five-year bonds in its latest sale, that’s more attractive than the 1.04% yield on five-year U.S. Treasury notes. But it’s much less than the 2.66% the state paid on five-year bonds in November and down substantially from the 3.70% it paid on bonds sold in March 2009.
“Retail investors are deeply ambivalent about bonds at these yields,” said Matt Fabian, an analyst at research firm Municipal Market Advisors in Concord, Mass.
The muni bond market, like the stock market, is finding that many investors would rather just keep their money in bank accounts paying almost nothing than take on the risk of loss.
But as this week’s bond sale demonstrated, if small investors stay away, institutional buyers have more leverage to demand higher yields. That could bring more individual investors back to the market.
For Lockyer, of course, the goal is to pay as low a rate as possible on new bonds. Interest expense on debt is borne by California taxpayers. Lockyer has a backlog of about $35 billion of voter-approved general-obligation bonds to sell in coming years to finance construction of schools, water systems and other public works. The next sale is expected in the first half of 2012.
Dresslar, Lockyer’s spokesman, said investors got used to “feasting” on high California bond yields in the last decade, at taxpayers’ expense. As interest rates have fallen across the board, he said, “Hopefully those days are over.”
