It’ll Pay to Wait on State Bonds

California goes to market today in a record $1.25-billion sale of general obligation bonds to fund state projects.

The offering is huge, even by Golden State standards. And it will be a good test of investors’ appetite for such tax-exempt municipal bonds, which are offering high yields to California residents--the equivalent of near-10% yields on taxable investments such as corporate bonds or bank CDs.

But if you’re looking to buy some of the California bonds, some pros’ advice is: Wait. You should get a better yield in the weeks ahead.

The offering doesn’t come at the greatest time, from the state’s viewpoint. The bond market has been roughed up in recent days, as some traders have dumped bonds of all kinds on worries about rising interest rates.

In the U.S. Treasury bond market, the yield on 30-year bonds has risen to 8.13% from 7.95% two weeks ago. The yield is rising because bond traders fear a quick turnaround in the economy, now that the Persian Gulf War is nearly over. Renewed economic growth would, in theory at least, increase demand for money and thus raise interest rates.

So it’s likely that the big initial buyers of the California bonds--major brokerages and institutional investors--will demand higher yields from the state than they might have just a few weeks ago. “I think the buyers will control the situation, just because of the size” of the offering, says Robert Gore, manager of muni bond trading at brokerage Crowell, Weedon & Co. in Los Angeles.

The bonds will be sold in maturities of one to 20 years, so you can pick your term. The interest is exempt from both federal income tax and California state income tax.

As for safety, some investors understandably are worried about California’s fiscal health, given the looming multibillion-dollar state budget deficit. But while one major credit-rating service has said it might downgrade California’s bonds, they remain of highest quality--rated AAA. Only 10 other states have that rating. General obligation bonds are backed by the state’s full faith and credit.

The minimum investment is $5,000, though brokers often expect investors to buy at least $10,000 worth of bonds. On Tuesday, traders were expecting yields in the following ranges:

* On the five-year bonds, around 5.4%. If your federal marginal tax rate is 31% (the official top rate now, though some high-income earners will effectively pay more), you’d have to earn at least 7.8% on a taxable investment to beat a 5.4% muni yield. What about Treasury securities as an alternative? Five-year T-notes yield just 7.6%.

* On the 10-year bonds, around 6.1%. That’s equivalent to an 8.8% taxable yield in the top federal bracket.

* On 20-year bonds, around 6.8%, equivalent to a 9.9% taxable yield. In contrast, Treasury bonds of that maturity pay just 8%.

As attractive as those yields are, some pros expect prices of the California bonds to get even cheaper as they begin trading over the next few weeks, thus boosting the yields to buyers who wait. Here’s why:

* The end of the war now seems certain to push all interest rates up further in the near future--if only temporarily--because investors are reacting in knee-jerk fashion to expectations of a stronger economy. Because interest rates had fallen so sharply between October and early February, many bond traders have big paper gains. That will encourage profit-taking.

* Even though yields on existing California bonds have risen slightly over the past two weeks, they’re still well below yields of muni bonds in general, thanks to the state’s still-high credit rating. The chart shows the average yield of an index of long-term California bonds versus the national Bond Buyer index of muni bonds. The figures show 30-year California bonds now yielding about 7% annually, while the national average yield of state bonds is close to 7.3%.

Because of that difference, many money managers are balking at jumping into the California bonds at their offering prices today, expecting instead to pressure bond dealers for better yields over the next few weeks. As an example, Bill Loring, manager of the $230-million Colonial California Tax-Exempt Trust mutual fund in Boston, says he is “probably not interested” in the bonds at current yields. “The market is still willing to pay a premium for California paper,” he says.

Andrew Johnson, head of the muni department at mutual fund giant Franklin Resources in San Mateo, says his firm “hadn’t decided” as of Tuesday whether it would buy at the offering.

What it comes down to is that the bond sale, like most such large offerings, is essentially a game of chicken: Brokerages that underwrite the bonds for the state will end up buying a large chunk to stay in good stead with Sacramento. They will then expect to sell the bonds to their customers--individuals and institutions--over the next few weeks. Thus, many individual investors can expect to be pitched the bonds by brokers in March.

If you get the pitch, just try to cut the best possible deal for yourself, especially if market interest rates are rising. Remember: Dealers will have a lot to sell. The previous record California general-obligation bond sale was a $700-million offering last September, so this $1.25-billion sale is indeed a whopper.

California vs. U.S. Yields Yields on California municipal bonds still are well below yields on muni bonds issued byother states, a sign of faith in the Golden State’s economy. Source: California Public Finance newsletter