The Sins of O.C. Are Paid for by Other Counties

Some big-name institutional investors, determined to exact a price from California municipalities for Orange County's bankruptcy, forced yields up higher than expected on two large county note offerings Thursday.

The deals, involving San Bernardino and Sacramento counties, set the stage for a potentially difficult note sale next week by financially ailing Los Angeles County, which must borrow $1.3 billion in advance of 1995 and 1996 tax payments.

San Bernardino and Sacramento counties both had to pay yields of around 4% on their notes. In contrast, the yield on an index of one-year notes from 10 major issuers nationwide, mostly big states, was at 3.79% as of Wednesday, according to the Bond Buyer newspaper.

The note offerings by California counties, school districts and other municipalities are a spring rite necessitated by the cash-flow problems they face during the year, waiting for twice-yearly tax payments from property owners.

By borrowing against those future tax payments each spring, usually via 12-month notes, the municipalities assure that they'll have cash in hand to pay bills until property tax payments arrive.

In the past, institutional investors such as money market mutual funds have been eager buyers of California municipal notes. But Orange County's bankruptcy last December--and the still-looming threat that the county may default on certain of its notes when they mature in July--has cast a pall over the note market this month, the peak month for such borrowings.

Some investors, particularly the mutual fund companies that face potential losses if Orange County walks away from its notes, have been waging a public campaign to shame Orange County into honoring its obligations. Their threat has been to either boycott note offerings by other California municipalities altogether, or demand higher yields on those notes they do buy.

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Since May 30, most of the California note deals that have come to market have been fairly small, and most have found ready buyers. But two big deals on Thursday suggested that the mutual funds' threats are having the desired effect:

* San Bernardino County, attempting to borrow $250 million in 12-month notes at a yield of 3.85%, found that it couldn't sell more than half the notes at that yield, according to county investment officer Sol Levin. One or perhaps two major mutual fund companies were said to be holding out for 3.95%, and the county's underwriter, Bank of America, finally agreed to that yield.

Significantly, San Bernardino was forced to pay that higher yield even though the notes were fully insured through letters of credit purchased by the county from major banks. That insurance effectively cost the county another 0.15% in interest.

* Sacramento County floated $260 million in uninsured 15-month notes at an annualized yield of 4.15%, in a deal underwritten by brokerage Morgan Stanley & Co. Unable to get the notes sold at its desired lower yield last week, the county decided to accept Morgan Stanley's 4.15% yield offer Thursday rather than compete with the gigantic note offering coming from L.A. County next week, said Sacramento County chief investment officer Christopher Ailman.

Partly because of Orange County's debacle, "We didn't have a lot of expectations this year" for robust investor demand, Ailman conceded.

To put those tax-exempt note yields in perspective, consider: At 3.95% for 12 months, the San Bernardino County notes are paying the equivalent of a 6.31% fully taxable yield for a California taxpayer in the 37.4% combined effective federal-state income tax bracket (taxable income of between $94,251 and $143,600 for joint filers).

In contrast, one-year bank CD yields in California now average 5.58%, according to rate-tracker Bradshaw Financial Network. And a one-year U.S. Treasury bill, which pays interest exempt from state taxes but not from federal, now yields 5.65%.

Of course, some investors may regard the difference between 3.85% (what San Bernardino hoped to pay) and the final yield of 3.95% as a small "Orange County penalty." It amounts to $250,000 in extra interest.

But the letter of credit, which San Bernardino has never before been forced to buy for its notes, in theory should have eliminated the penalty--instead of adding to it.

And for mutual funds and other angry institutional investors trying to make a point, the relative trouble that San Bernardino and Sacramento counties had in trying to float their debt is a victory of sorts--especially with L.A. County's massive note offering on deck.

Keeping up the pressure, a portfolio manager at the giant Franklin Group of mutual funds in San Mateo reiterated Thursday that his funds won't buy Los Angeles County notes unless they carry some form of insurance, or "enhancement."

"We have suggested that they offer a portion of it enhanced," said Robert Schubert, a senior portfolio manager at Franklin.

To avoid being held hostage by institutional investors, L.A. County is attempting to drum up heavy interest for its notes among wealthy individuals in California. And indeed, if the L.A. County notes yield close to 4% tax-free, like the San Bernardino notes, the taxable-equivalent yields will be attractive for many high-tax-bracket investors who can afford the $25,000 (or higher) investment minimum--and who are willing to accept the risk that goes along with directly holding debt of a fiscally strapped municipality.

Even so, it's highly unlikely L.A. County will be able to raise the full $1.3 billion without mutual funds and other big investors stepping up. And they demonstrated with the San Bernardino and Sacramento notes Thursday that they are intent on driving a hard bargain as retribution for Orange County's brazen threat to renege on its debts.

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Lucrative Yields?

The 3.95% tax-exempt yield that San Bernardino County will pay on its 12-month notes sold on Thursday is equivalent to sharply higher taxable yields, depending on your tax bracket. What a bank CD would have to yield to equal a 3.95% tax-exempt yield, for married taxpayers in these taxable income ranges: $49,039 to $61,974: 5.97% $61,975 to $94,250: 6.05% $94,251 to $143,600: 6.31% $143,610 to $214,928: 6.81% $214,929 to $256,500: 6.86%

Note: Based on combined effective federal-state tax rates.

Source: California Municipal Bond Advisor

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