Even California Shows Halo With Insatiable Demand: Muni

California’s swelling budget deficit is proving no match for investors desperate to boost returns with municipal interest rates close to 45-year lows.

The extra yield investors demand to hold debt of California issuers instead of top-rated local-government bonds matched a three-year low on May 15, according to Bloomberg Fair Value data. The day before, Governor Jerry Brown proposed cutting state workers’ pay 5 percent to save money after the state’s spending gap grew 71 percent since January.

Across the U.S., taxpayers are benefiting as the most money in three years floods into muni mutual funds while coupon and principal payments are set to exceed issuance through August. The flow is keeping the yield penalty on Alabama municipalities from growing even after state lawmakers failed last week to help bankrupt Jefferson County bridge a budget gap, said Tom Barnett, finance director of Birmingham, the county seat.

“There’s a shortage of bonds out there,” said Paul Mansour, managing director at Hartford, Connecticut-based Conning, which oversees about $10 billion of municipal bonds. At the same time, “there’s a rush for yield, and it’s masking the differences” in issuers’ credit quality, he said.

Buyers are seeking riskier credits as the supply of new bonds dwindles while defaults in the $3.7 trillion market for local debt have slowed. Twenty-six municipal issuers have defaulted for the first time in 2012, half the number for the same period of 2011, according to Municipal Market Advisors data through May 15.

Haven Market

New municipal bonds may remain scarce for several months. Coupon and principal payments available to reinvest will total $113 billion from June through August, outstripping new issuance by about $20 billion, according to Chris Mauro, head U.S. municipal strategist at RBC Capital Markets in New York.

Investors looking for a haven from Europe’s debt crisis have added about $12 billion to U.S. muni funds this year, the best annual start since 2009, Lipper US Fund Flows data show.

That’s helped keep local-government interest rates close to the lowest since the 1960s, even after they climbed last week. Twenty-year general-obligation bonds yield 3.75 percent after touching 3.6 percent in January, the lowest since 1967, according to a Bond Buyer index.

“Taking more risk to get higher yields may be a strategy that plays out well over the next six to 12 months, but typically environments where that takes place don’t end well,” Chris Alwine, head of municipal funds at Vanguard Group Inc., which manages $127.5 billion in municipal assets, said in an interview in New York.

Economy Risk

One risk for buyers of weaker credits is that economic growth may falter, putting more pressure on cities that are still rebounding from the 18-month recession that ended in 2009, said Mansour.

“If another recession hits in two or three years, their choices are going to get even grimmer,” he said. “That’s what scares us.”

Most economists project growth to continue. The U.S. economy will expand 2.3 percent this year, compared with 1.7 percent in 2011, a Bloomberg survey of banks and securities companies shows.

The extra yield on issues from California, the lowest-rated U.S. state by Standard & Poor’s, fell to 0.82 percentage point last week, matching the smallest since December 2008, according to data compiled by Bloomberg. On May 14, Brown said his state’s deficit had grown to $15.7 billion from $9.2 billion in January. The state’s debt has returned 4.7 percent this year, compared with 4.1 percent for the broader muni market, S&P index data show.

Shielding Alabama

The appetite for risk is also cushioning Alabama municipalities, which had already been paying an extra 0.25 percentage point to borrow because of the proximity to Jefferson County, said Barnett in Birmingham. The county in November filed the biggest municipal bankruptcy in U.S. history.

The Alabama House last week refused to consider allowing the county to raise taxes, which may lead to further service cuts and more missed bond payments. The development won’t force up yields, Barnett said.

“With nominal levels where they are, everybody is attracted to any extra yield they can get,” he said. “That’s working to bring down any penalty for Alabama paper.”

Rockland County, New York, is also drawing demand, even after having its rating cut three levels on May 10 by Moody’s Investors Service because it hadn’t closed a deficit of more than $40 million.

The county of about 312,000 across the Hudson River from Westchester County has had its bond grade cut twice this year by a total of five levels, to Baa3, the lowest investment grade.

A Rockland bond maturing in February 2017 traded at an average yield of 1.7 percent on May 16, little changed from the week before, data compiled by Bloomberg show.

Bonds rated BBB have earned 6.4 percent this year, compared with 2.5 percent on AAA and 4.1 percent for the total municipal market, according to Bank of America Merrill Lynch data.

The bond shortage is “granting broad salvation to many of the market’s sinners,” Matt Fabian, managing director at Concord, Massachusetts-based MMA, wrote in a May 14 report.

Following are pending sales:

MASSACHUSETTS is set to issue $350 million of general-obligation bonds as soon as this week to help finance capital projects. The debt will price competitively. The longest maturity for the bonds is 2042, according to offering documents. S&P rates Massachusetts AA+, second-highest. (Updated May 21)

VIRGINIA TRANSPORTATION BOARD plans to borrow $600 million of revenue debt as soon as this month via competitive bid. Proceeds will help finance capital projects, according to documents from the board’s April 18 meeting. The bonds will mature annually from 2013 through 2037. (Updated May 18)

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