U.S. bond plan lowers muni yields


California on Wednesday became the biggest issuer so far of a new type of municipal bond that has caused investors to rethink the muni market overall -- in a way that is driving down bond interest rates.

Robust investor demand allowed Treasurer Bill Lockyer to boost the size of a planned $4-billion bond offering to $6.85 billion. Proceeds from the securities will finance voter-approved infrastructure projects.

Included in the deal were $5.23 billion of bonds sold under the federal government’s new Build America Bonds program, part of the economic stimulus package Congress approved in February.


Unlike conventional munis, which pay interest that is exempt from federal income tax, Build America Bonds are subject to federal tax. That means California paid a higher gross yield on the bonds than it would have paid on conventional munis.

But the state still wound up saving money, because the U.S. picks up 35% of the interest cost of bonds issued under the Build America Bonds plan.

Example: California paid an annualized rate of 7.4% on the $3 billion of 30-year bonds in the offering. With Uncle Sam paying 35% of that, the net rate paid by the state is 4.8%.

That is well below the current 5.65% market interest rate, or yield, on recently issued 30-year California tax-free bonds.

Lockyer estimated that the Build America Bonds in the sale would save the state $1.15 billion in interest over the next 30 years, compared with conventional munis. “It’s a good result for the taxpayers,” he said.

For investors, the launch of the Build America Bonds plan has stoked a rally across the tax-free muni bond market in recent days, driving bond prices up and yields down.


Why the rally? One expectation is that rising issuance of taxable bonds by state and local governments under the Build America Bonds program will mean fewer conventional munis coming to market this year. So some investors who want tax-free income are grabbing what they can.

“There’s a fear that this is going to create a shortage of large, long-[term] tax-free issues,” said Ben Stern, a principal at investment bank De La Rosa & Co. in Los Angeles.

There’s something else going on as well: The yields that money managers, pension funds and other big investors are accepting on the taxable Build America Bonds are forcing conventional-muni investors to rethink what is a fair yield on tax-free bonds.

Many investors have been wary of muni bonds because of state and local budget woes. But the market now seems to be saying that investors have been demanding too much of tax-free issuers, including California -- a point Lockyer has been arguing for the last year.

“This is like a refocusing of the muni market,” said Matt Fabian, senior analyst at consulting firm Municipal Market Advisors in Westport, Conn.

Still, some analysts said it wasn’t clear that muni yields could continue to tumble, given investors’ concerns about the creditworthiness of many state and local governments.


Cash-strapped California will be forced to borrow at least $13 billion via short-term notes in July to fill a budget gap until tax revenue rolls in later this year. Lockyer wants the U.S. Treasury to guarantee those notes because he isn’t sure jittery investors will lend the money without that backstop.