California lifts IOU sale to $5 billion and sets final yields

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Another rush of investor orders today allowed California to boost its sale of short-term notes to $5 billion, ending the cash emergency that threatened to send the state to Uncle Sam for a loan.

Treasurer Bill Lockyer said institutional investors placed $2 billion in orders for the IOUs, on top of the $3.92 billion in orders received Tuesday and Wednesday from individual investors.

The offering, initially for $4 billion, was expanded to $5 billion because of demand. Individual investors will have all of their orders filled; institutions will get the rest.

The state set the annualized tax-free interest rates on the notes at 3.75% for the seven-month issue (maturing next May 20) and 4.25% for the eight-month issue (maturing June 22).

Those yields matched the preliminary numbers Lockyer gave on Wednesday, although on Tuesday the state had estimated that the yields could be as high as 4% on the seven-month note and 4.5% on the eight-month issue, depending on investors’ response.

Even at the low end of the state’s original range the yields are juicy, because the interest is exempt from state and federal income tax. A 3.75% tax-free yield is equivalent to earning a fully taxable yield of 5.74% for someone in the 34.7% combined state and federal tax bracket.

California typically sells short-term IOUs each year at this time to patch its seasonal budget shortfall. But the credit crisis has caused many investors to abandon the municipal debt market, raising fears that the state couldn’t get the cash it needed. Gov. Arnold Schwarzenegger warned on Oct. 3 that the state might have to go to the federal government for a loan.

Investors ought to be happy with the final yields. But from taxpayers’ point of view, the state paid a high price to get the deal done. Massachusetts last week paid a yield of just 2.2% on similar short-term notes, although its offering was much smaller.