(Bloomberg News) 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.
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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.
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