Did California overpay in bond deal?

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Investors who bought the $5.2 billion of long-term bonds that California sold Wednesday already have booked a tidy paper profit on them.

That raises the question of whether the state overpaid in the deal.

Short answer: Yes, it did.

California Treasurer Bill Lockyer sold the 25- and 30-year taxable municipal bonds under the federal government’s new Build America Bonds plan. The program provides for the U.S. Treasury to pick up 35% of the interest cost on the securities, as a way to help state and local governments fund job-creating public works projects.

So even though California paid an annualized yield of 7.4% on the 30-year issue in the deal, with the federal interest subsidy the state’s net cost of 4.8% was less than what it would have had to pay on conventional tax-free bonds (probably around 5.6%).

Once trading in the new bonds began today in the so-called secondary market, investors who weren’t able to get their hands on the bonds in the sale Wednesday bid aggressively for them. That drove the yield on the 30-year issue down as low as 7.1%, according to traders.

If California had been able to pay 7.1% instead of 7.4% on the bonds, it would have saved a bigger chunk of money for taxpayers over the next three decades.

The strong reception for the bonds in the secondary market suggests that the Wall Street firms that handled the sale for California, led by Goldman Sachs and JPMorgan, might have been able to strike a better deal for the state.

Any time yields tumble on newly issued bonds, it looks like underwriters did a favor for the initial buyers at the issuer’s expense. The underwriters also could have done themselves a favor, if they held a significant number of bonds in their own inventory for later sale.

I asked Lockyer whether the underwriters should have pressed to get the state lower yields in the offering, given the strong level of investor interest.

‘We worked hard to try to get the right price,’ he said. Noting that the Build America Bonds are a new animal, Lockyer said it was ‘very hard to predict [pricing] when it’s a brand-new flavor of bond.’

Yes, but that’s what underwriters get paid to do.

-- Tom Petruno