California State Tax Free Bonds

Despite all the talk about California going bankrupt (which it can't, legally) or being like Greece, investors scooped up the state's tax-free general obligation bonds this week. Demand was strong enough that Treasurer Bill Lockyer increased the size of the sale by $500 million to $2.5 billion today.

Individual investors bought about 55 percent of the bonds, primarily the shorter-term maturities, during a two-day retail order period that ended Wednesday. Institutional investors bought the rest of the bond issue today.

Strong demand allowed the state to pay slightly less than originally planned. Final yields ranged from 1.17 percent for the March 2012 maturity to 5.65 percent for bonds maturing in March 2040. The state had expected to pay 5.7 percent on the 2040 maturity.

"I think (investors) recognize what the treasurer and state officials have been saying forever, that California is still a sound investment. Despite all those negative headlines and our ratings (California has a lower credit rating than any other state), our likelihood of default is virtually zero."

California was lucky that the overall supply of tax-free bonds both newly issued debt and previously issued bonds trading in the secondary market has been unusually small lately. Meanwhile, demand for tax-free bonds has been strong because many investors expect tax rates will be going up. Strong demand and limited supply means investors were willing to pay a slightly higher price and accept a slightly lower yield than some market experts had expected.

Supply has been limited because many states, instead of issuing tax-free bonds, have been issuing Build America Bonds, which pay taxable interest. These bonds, nicknamed BABs, were created by last year's federal stimulus act. States and other government issuers sell them to finance infrastructure projects. Because they are taxable, they pay higher interest rates than tax-free bonds, but the federal government reimburses states for 35 percent of the interest.