State’s Counties, Schools to Find Out How Costly O.C. Debacle Is

California’s counties and school districts will soon find out exactly how badly Orange County’s fiscal debacle has poisoned the money well.

As much as $8 billion in short-term notes will be floated by California municipalities over the next month or so, an annual rite as local governments raise cash to tide them over until future tax payments arrive.

In years past, these short-term notes have generally been snapped up by institutional and individual investors, who considered the debt among the safest paper they could own. It matured in just 12 or 13 months, after all, and the interest was exempt from state and federal income tax.

But Orange County’s bankruptcy last December changed many investors’ benign approach to short-term municipal debt in California.

First came the shocker that Orange County might simply walk away from certain of its note obligations, arguing that they were illegal to begin with.

But that threat doesn’t appear to have troubled note investors as much as a seemingly less noxious Orange County action: Its request in February, approved by the bankruptcy judge, to forgo the normal set-aside of reserves to cover short-term notes maturing this July.

The county said it needed the money for other purposes in the near-term. But to note holders, the abrogation of the set-aside agreement raised fears that other California note issuers might also begin to look upon standard set-aside requirements as a “maybe we will, maybe we won’t, depending on how we feel” issue.

That may seem a grossly exaggerated concern, of course. The vast majority of municipal borrowers obviously have nothing to gain by angering their investor-lenders. Wall Street knows that.

But one powerful group of investors--mutual funds--have nonetheless been engaged in a full-court press on this issue. Several big fund companies, including Alliance, Benham Group and Franklin Resources, last week fired off a letter to Gov. Wilson and a host of other California politicians, warning that fallout from Orange County’s decisions could shake the municipal note market in June.

Some fund companies, like Benham, have said flat-out that they don’t think they’ll buy any short-term notes floated by California issuers this spring unless the notes carry some kind of third-party guarantee--private insurance, or “letter of credit” backing by a major bank. In either case, the cost of that guarantee would be borne by the municipality and ultimately by its taxpayers.

Other fund managers have been less specific about what they may and may not buy. “A letter of credit would take care of it for us,” said Robert Schubert, senior portfolio manager for Franklin’s California tax-free money market fund. “Without a letter of credit, it becomes iffy,” he said.

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The cynical view of the fund industry’s threats is that fund managers are simply interested in extracting the highest possible interest rate from borrowers, for the benefit of fund investors.

And indeed, every note or bond offering is essentially a poker game between the issuer and investors. The seller wants to pay the lowest possible yield, while the buyer wants to earn the highest possible yield.

The funds, however, say they have a more basic concern here, which is obeying Securities and Exchange Commission guidelines regarding the safety level of money market fund investments. SEC rules demand that funds buy only the highest-rated securities for money funds. Orange County’s abrogation of its set-aside agreement, the funds argue, has created a major element of doubt about California notes of all types.

Therefore, to avoid potential legal problems down the road--however remote the chances--some fund companies are balking at lining up to buy California notes as if it was business as usual.

For investors, including those who own shares in California tax-free money funds and those who might want to buy short-term notes directly this June, what’s the bottom line?

Short-term muni yields, like taxable money market yields, are already higher than they were in January, a function of the market’s expectations that the Federal Reserve Board isn’t yet ready to loosen credit.

The average single-state muni fund yields about 3.79% now (that’s a 30-day compounded yield), and California-only funds have tracked that national average fairly closely. Higher-tax-bracket investors will find that a 3.79% tax-free yield is equivalent to a taxable money fund yield above the 5.67% average that those funds now pay.

So if California municipalities are forced to pay sweeter yields to float their notes next month, California investors could find that the yield advantage in keeping short-term monies in tax-free money funds instead of taxable funds could be significant.

But there’s also a risk here for tax-free money fund investors. Funds that balk at locking in the expected 4%-plus tax-free yields on the 12- to 13-month notes most of these borrowers will issue could suffer later in the year if the Federal Reserve begins to ease credit, pushing all short-term interest rates (and probably longer-term rates) down.

For that reason, investors who have the wherewithal to invest directly in short-term California notes (you generally must buy in $25,000 blocks, through a broker), and who believe that interest rates are definitely headed lower over the next year, should be on the lookout for lucrative note deals in coming weeks. The borrowers’ pain can be your gain.

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Higher Returns on Short-Term Munis

Yields on money market funds that invest in short-term tax-free municipal securities have risen this year even as longer-term yields have fallen. Average 30-day compound yields for state-specific money funds:

May 1995: 3.79%

What’s a Tax-Free Yield Worth?

For a California taxpayer in the 37.4% combined state and federal tax bracket (taxable income of between $94,251 and $143,600) a 3.79% tax-free yield is worth the same as a 6.05% fully taxable yield. By contrast, the average taxable money fund now yields 5.67%.

Source: IBC / Donogue