Thursday, October 16, 2008

Managing California's cash ain't like dusting crops

On October 3, California Governor Arnold Schwarzenegger warned that his state might need a Federal loan of $7 billion. This week we find out if that scenario has been averted as California is marketing $4-5 billion in "Revenue Anticipation Notes" or RANs. These will be tax-exempt securities. A RAN is used by municipalities to manage cash flows while waiting for tax and other revenue to be collected.

Originally the deal was to be $4 billion, with $1 billion maturing in May and the other $3 billion in June 2009. Retail orders were taken Wednesday, with dealers getting $3.8 billion in orders. The deal has been increased to $5 billion, with dealers taking institutional orders Thursday.

The yield on the bonds is not yet set. The original sales literature indicated a range between 4 and 4.75%. But with orders coming in so strong from retail, the May maturity will probably yield 3.75% and June piece 4.25%.

At 4.25%, the rate on the California bonds would be about equal to 6-month LIBOR on an absolute basis, and is similar to current reset levels on 7-day variable rate municipals. The 4.25% is also about 6.5% on a taxable equivalent basis, more like 7% if you are a California resident. Any way you slice it, its a lot of yield.

The challenge in placing these notes is the combination of California's economy and the sheer size of the note. A note of this kind would normally be attractive for money market funds and other short-term buyers, especially at that rate. But currently money markets are strapped for liquidity themselves, and have been focused on buying bonds with overnight maturities (or put options) to ensure the fund can meet redemptions. So buying a longer-term bond is probably out of the question.

Vulture buyers entering the municipal market are probably looking elsewhere. If you want to buy munis cheap, you should buy longer-term securities, where a recovery will result in a price pop. Currently 15-year munis can be had for at yields over 5.5%. If that rate were to fall to 4.5%, the owner would enjoy a 8-9% price return. With the short-term California bond, investors best return is going to be the yield.

And of course, California is at the epicenter of the housing crunch, which is likely to weigh on property tax revenues for some time. Offsetting this somewhat is the diversity of their economy and the benefits of Proposition 13. Bear in mind also that local governments are the primary beneficiaries of property taxes, whereas the state revenues are primarily sales and income taxes.

So are these California bonds worth the risk? Perhaps California will have more budget difficulties than other states, but ultimately the state's budget will come down to tough political decisions rather than an inability to finance their debts. Put another way, I'd rather own 9-month state of California paper at 6.5% taxable equivalent levels than most corporate bonds. And its investors thinking along those lines that will wind up buying up these bonds.


Anonymous said...

I'm puzzled by the collapse in highly rated closed end muni bond funds. That Nuveen's "NUC" as an example. It closed today at $9.32, which represents a yield of about 8% and discount from NAV of about 20%. About 80% of the bonds are aa or aaa. Even with the news of the insurers bail out plans today, t was down. I understand the leverage and the freeze in the auctions.
But a wealthy resident of CA with 40% marginal income tax rate this represents a 13% return at these price.
What am I missing?

PNL4LYFE said...


I think this is just one example of a market with terrible technicals. There are people who have to sell, and the would-be buyers are waiting for lower prices because they are either scared or savvy. I think a lot of 'smart money' investors would agree that there is great value here, but they don't want to catch the falling knife. Over the last year, people have been conditioned to the reality of this environment; every sale has been a good one, and every purchase has been a bad one. Until all the forced sellers are shaken out, I think every rally will be met with more selling.

Accrued Interest said...

The problem with closed end funds is that they may be forced to delever into an awful market. That doesn't explain 20%+ discounts we're seeing, but I agree with PNL there might be more pain to come. I've bought some recently, but I'm fully aware there might be more pain to come.

I also think CEF are an example of something conservative investors bought and its turned out to not be conservative at all. So they want out. "Conservative" investors have been burned on stuff like GE bonds, agency preferreds, ARS, etc. They aren't playing around any more.

Andrew Abraham said...

We have been debating on if it is a good time to start buying Muni Bonds..was hoping you might be able to share your thoughts and insights..Hearing about CA... makes me more skeptical... would like to hear your opinions..