As Interest Rates Rise, State Opts to Speed Up Sale of Deficit Bonds

With interest rates on the rise, California will speed up the sale of $6 billion to $7 billion worth of bonds approved by voters in March to help refinance the state’s accumulated budget deficit.

State Treasurer Phil Angelides announced Thursday that the state would start selling the deficit bonds May 4, about a month earlier than planned. They will carry a fixed interest rate and will be the first installment of $15 billion in deficit bonds authorized by Proposition 57.

Proceeds from the bond sale, one of the largest public finance offerings in U.S. history, will be employed to refinance short-term borrowing used to cover the state budget deficit.

Angelides, who opposed the bond issue on last month’s ballot, said he hoped that the bond sale would mark the end of borrowing to cover operating costs.

For four years, state government has run record deficits as officials in Sacramento refused to bring spending into line with tax revenue.

Angelides told reporters in Sacramento that a second installment of bonds -- $5 billion to $6 billion -- would be sold between May 24 and June 15. Unlike the early bonds, these will carry a variable interest rate.

Gov. Arnold Schwarzenegger is counting on a total of $12.3 billion from the bond sales in his proposed budget for the coming fiscal year. The remainder of the bonds authorized by voters would be available for future sale.

In response to a question, Angelides acknowledged that the rise in interest rates was one of the reasons that state officials were accelerating the bond sale, which was originally planned for early June.

As interest rates rise, the state’s cost of borrowing increases.

Interest rates on long-term bonds have already risen sharply in recent weeks, as investors have bet that the Federal Reserve will begin to tighten credit this summer amid strong U.S. economic growth and rising inflation.

The average tax-free yield on an index of 20-year California general obligation bonds compiled by Bloomberg News stood at 5.06% on Thursday, up from 4.74% on March 15.

Many investors have stepped away from the bond market, unsure how high interest rates might go, said George Strickland, a principal at Thornburg Investment Management in Santa Fe, N.M.

Institutional investors nationwide are well aware of the California deficit-bond deals, and many have previously expressed interest in buying the securities, investment bankers say.

Because the deficit bonds are expected to be viewed as a higher-grade security than conventional California general obligation bonds -- they will be backed by a quarter percent of the state sales tax -- the field of potential buyers may be substantial, said Steven Permut, a bond portfolio manager at American Century Investments in Mountain View, Calif.

Despite California’s dismal credit rating -- the lowest of any state -- virtually no one believes that the nation’s most populous state will fail to pay its bills. So at some interest rate, the huge deficit bond issue is sure to be sold, analysts say.

But with interest rates in general on the upswing, the potential cost to the state is mounting.

“This is not going to be an easy one” for the state to sell, said Dean Gestal, a managing director at San Francisco-based Stone & Youngberg, a dealer in municipal bonds.

A further complication is that the sale is set to begin May 4, the date of the next meeting of Federal Reserve policymakers. Hints the Fed drops that day about its plans for interest rates could rile the bond market and drive up the yields investors demand on the California bonds.

Bond underwriters will begin to take orders from individuals on April 30.

Angelides urged Californians to buy the bonds, calling them a good investment. Interest on the bonds will be exempt from state and federal income taxes, which should make their yield attractive to affluent Californians.

Steven Zimmermann, managing director of Standard & Poor’s bond rating agency in San Francisco, said the sale “still doesn’t solve the big problem,” with California facing a $14-billion shortfall in the 2004-05 state budget.

He noted that California continues to spend more than it takes in, so balancing the budget remains a formidable task.