Needy cash to needy state?

California Treasurer Bill Lockyer will have to borrow $10.5 billion next month. That's no small chunk of change. But the way it looks now, many investors will be lining up to hand him their money.

Despite the state's global reputation for fiscal mismanagement, and the lowest credit rating in the Union, California is in the right place at the right time to put out its hat. The confluence of events can be summarized like so: Cash-needy state meets needy cash.

For the last five months, investors have grown increasingly confident that the U.S. economy no longer faces collapse. The debate has shifted to a question of when, and how strongly, business and consumer activity will recover.

That mind-set change was the equivalent of dynamiting part of a dam that has been holding in huge sums of cash earning virtually zip, as the Federal Reserve keeps short-term interest rates near zero.

The average annualized yield on taxable money market mutual funds now is a record low 0.07%. That means $10,000 would earn $7 in interest over 12 months. After taxes, what's left is about enough to fund a fast-food meal -- if you don't supersize the French fries.

No wonder, then, that stocks and corporate bonds have rocketed in value since early March as many investors have gone in search of better returns on their cash.

California's mammoth debt sale stands to fill a need from investors who may not be willing to take chances with stocks or bonds, but who can't bear just to sit still in money funds and other short-term accounts.

Lockyer expects to sell $10.5 billion in so-called revenue anticipation notes, or RANs. The notes typically are issued by the state, large counties and other municipalities in summer or fall, to bridge the gap between near-term spending needs and tax revenue that will arrive later in the fiscal year.

As securities go, RANs normally aren't controversial -- or very risky. In California's case, the $10.5 billion in notes most likely would mature in May or June, so investors' money would be tied up for just eight to nine months.

The appeal of the state's RANs is expected to be their yield compared with what's available on other short-term securities. It isn't yet clear what Lockyer will have to pay for the money, except that it almost certainly will be more than the 0.4% annualized tax-free yield that Ventura County, Orange County and other entities have recently paid on RAN offerings.

In other words, investors are expected to penalize California for its poor financial reputation. But in a market so starved for decent returns, the surprise could be how low a penalty the state will pay.

In October, even amid the financial markets' meltdown, individual investors turned out in droves to buy a RAN deal from the state. Demand was so strong that Lockyer was able to boost the offering to $5 billion from $4 billion.

Investors were paid an average annualized yield of 4% on the securities. Because the interest is exempt from state and federal income taxes for California residents, that 4% was the equivalent of a much higher taxable yield, depending on the buyer's tax bracket.

Despite the much larger size of the RAN deal Lockyer is planning for September -- and despite California's image of fiscal dysfunction -- bond traders and fund managers were telling me this week that they thought the state might end up paying as little as 2.5% on the securities, given expected demand from yield-hungry investors.

(FYI, investors who are interested in the notes must place orders via a brokerage; more information on the deal will be available soon.)

The lower the yield, the better for taxpayers. But as with so many other markets that have benefited since March from investors' renewed hunt for fatter returns, the question is whether the rate on the RANs will adequately compensate for the risk.

Lockyer has said the state would never default on its debts, and there's good reason to believe him. But no municipal security is 100% risk-free.

Imagine that the California economy keeps sinking, and sometime later this year or early next year the state is staring at another huge hole in its budget. Despite Lockyer's assurances, some RAN investors at that point might begin to wonder if they'll be paid on time.

If, for whatever reason, you had to sell a RAN in the market before it matured, a new budget crisis could mean that potential buyers wouldn't pay you full face value.

"There could be price risk in the notes," said Todd Pardula, a money fund portfolio manager at American Century funds in Mountain View, Calif.

I'm not suggesting that is likely. And because most investors who buy RANs hold them to maturity, any market fluctuations probably wouldn't matter in any case.

I think the bigger issue here is the extent to which investors have warmly embraced bonds and other fixed-income securities across the board this year, maybe without fully understanding all of the risks they entail -- not short term so much as longer term.

One key risk for corporate and municipal bonds is that the economy could worsen instead of improving, pushing more borrowers into default. That could drive interest rates higher on most or all corporate and muni issues if investors collectively decided that yields were too low relative to the possibility of trouble.

Rising market interest rates would depress the prices of older bonds issued at lower rates. That wouldn't be fatal, but it would hurt if you had to sell. The other big risk is inflation. If it were to zoom in the next few years -- the end result of the government's decision to pump huge sums into the financial system to keep it afloat -- fixed-rate bonds would be ravaged.

At the moment, deflation is a far greater concern than inflation. But investors who are mulling locking in yields on longer-term bonds at this point should at least take the time to ask, "What if?"


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