Robust Demand for Tobacco Bonds

California got a rousing reception Wednesday for the first installment of bonds that will help plug the state’s budget gap.

Investors snapped up $2.6 billion of bonds that are backed by future payments owed the state by the tobacco industry under a 1998 liability settlement.

The bonds were sold in maturities ranging from five years to 40 years, according to underwriters led by Citigroup Global Markets Inc. Demand from big investors was so robust that California paid yields well below what was expected.

For example, the 30-year bonds were sold at an annualized tax-free yield of 5.68%. On Monday, some analysts predicted investors would demand more than 6% on those securities, given concerns about the tobacco industry’s financial health and the state’s own fiscal woes.

The bonds include a provision requiring the governor to pledge that he would seek to use tax revenue to repay the securities if the tobacco firms renege.

Bill Fitzgerald, a municipal bond fund manager at Nuveen Asset Management in Chicago, said the bonds’ appeal stemmed in part from the way they were structured: Under terms of the deal, the state has a strong incentive to retire them well before they mature, he said.

That could mean that the 40-year bond will be an 18-year security, he said.

Other investors said the tobacco bonds have become more attractive as yields on competing bonds, such as U.S. Treasury issues, have tumbled recently.

The bonds are the first phase of more than $15 billion in planned borrowing by the state to close a gaping budget deficit. But other pieces of the plan are in jeopardy because of lawsuits contending that the borrowing violates the state constitution.

The tobacco bonds also contained a warning of a possible court challenge by the American Heart Assn., which opposes the bonds, Reuters reported.

-- Tom Petruno