Some Investors to Gain From State’s Budgetary Crunch

The state of California will borrow a record amount of short-term money during the next two weeks to close its horrendous budget gap. For individual investors hungry for high short-term returns, the state’s cash needs spell opportunity: Depending on your tax bracket, the yields on this debt could be lucrative.

Next Wednesday, California will sell $4 billion in revenue anticipation warrants (RAWs) maturing in 22 months (on April 25, 1996). On July 27, the state will borrow another $3 billion via revenue anticipation notes (RANs) maturing in 11 months (on June 22, 1995).

The unprecedented short-term borrowings have been necessitated by the state’s continuing budget woes: The weak California economy has depressed tax revenue since 1990, while the Legislature has been unwilling since then to make the deep cuts in spending that would balance the budget.

Hence, California has continued to roll over its growing deficits and now must go hat in hand to investors for a mammoth short-term loan.

Despite the size of the borrowing, Wall Street remains confident in California’s ability to repay these debts on time--even though a long-term solution to the state’s chronic cash shortage remains an issue of heated debate in Sacramento.

Moody’s Investors Service and other credit- rating agencies are expected to rate the RAWs and the RANs, and many analysts expect most of the securities to get the highest safety rating.

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But the state has in effect been forced to buy investors’ confidence: The bulk of the RAWs will be guaranteed by a syndicate of major banks and other institutions, which have agreed to purchase the securities from investors at maturity if the state can’t repay them for any reason. The banks will get a fee for the guarantee, adding yet another taxpayer-borne cost to this deal.

For taxpayers who also are investors, the state’s need for cash means a chance to profit even as you pay. Though the exact yields on the RAWs and RANs won’t be determined until the securities are sold, Wall Street now expects the fixed-rate RANs to yield between 4% and 4.3%, annualized, over their 11-month life. In addition, some of the RANs will be issued with floating rates.

The bank-guaranteed RAWs are expected to yield 4.5% or better, annualized, over their 22-month life. Yields on the non-guaranteed portion of the RAWs could approach 5%.

Because those yields are exempt from federal and state income tax, they are equivalent to substantially higher taxable yields, such as on bank savings certificates. The accompanying chart shows what 4% and 4.5% California tax-free yields are worth if fully taxed.

So the question is, are the RAN and RAW yields likely to be better than anything you can find today on taxable securities of the same maturities ?

That depends. Consider: If the 11-month RANs pay about 4%, that’s a taxable-equivalent yield of 5.91% for a couple earning between $38,001 and $48,456. One-year bank CDs, which are fully taxable, pay about 4% today on average, so a CD owner would plainly be better off in a RAN yielding the taxable equivalent of 5.91%.

But compared to yields on U.S. Treasury securities--which are subject to federal tax but not state tax--RAN and RAW yields may look much less appealing. Based just on the 28% federal tax rate in the income bracket mentioned above, a 4% RAN yield would be worth a 5.55% one-year T-bill yield. That’s only slightly above the current actual 5.53% T-bill yield.

Higher-income Californians generally will be better-rewarded, especially in RAWs. But that may not be true for investors subject to the federal “alternative minimum tax.” Those investors should definitely contact a tax adviser before buying.

Other details on the RAN and RAW offers:

* Major banks and brokerages statewide are taking orders now. Though the official minimum is $5,000, many banks and brokers want individuals to put up at least $20,000 to $25,000.

* You won’t know the yield you’re getting until the deals are finalized--so there’s a risk that yields could come in lower than expected. Another option is to wait to buy in the “after-market”--that is, after the debt is issued and begins to trade.

* Interest on both the RANs and the RAWs is payable at maturity, so you’ll get your return in one lump sum rather than in installments. This may be a problem for investors who might otherwise be interested in the 22-month RAWs but who need current income.

Assessing Muni Yields

California will issue a record amount of short-term (11- to 22-month) debt in coming weeks, and the annualized tax-free yields are expected to be in the 4%-to-4.5% range. Here are the equivalent taxable yields in various tax brackets, for married filers.(Single filers’ tax rates are slightly higher.)

Combined Equiv. taxable yield Joint taxable fed./state if tax-free yield is: income tax rate 4.0% 4.5% $38,001-$48,456 32.3% 5.91% 6.65% $48,457-$61,240 33.8 6.04 6.80 $61,241-$91,850 34.7 6.13 6.89 $91,851-$140,000 37.4 6.39 7.19 $140,001-$212,380 42.0 6.90 7.76 $212,381-$250,000 42.4 6.94 7.81 $250,001-$424,760 45.6 7.35 8.27

Source: California Municipal Bond Advisor