California Pays Costly Yields on Tobacco Bonds

California was forced to pay much higher-than-expected yields Wednesday to sell $3 billion in tobacco settlement bonds, in a deal that underscored investors’ concerns about the state’s budget woes.

The tax-free yields of as much as 7% on the longest-term tobacco bonds also were another sign of the general weakness in the municipal bond market, until recently a portfolio star for investors since 1999.

California and other states have been using bonds as a way to advance themselves some of the $200 billion that major tobacco companies in 1998 agreed to pay over 25 years, in a pact that settled the states’ health liability suits against the firms.

The bonds are backed by the tobacco companies’ future payments and are viewed as investment-grade quality by leading credit-rating firms.

But brokerages handling the California sale Wednesday found that institutional investors balked at the 6.5% yield that had been offered to individual investors on the longest-term bonds earlier in the week. It took 7% to sell those securities, which officially mature in 2041 but are expected to be paid off by 2021.

To put that yield in perspective, a 7% tax-free return is equivalent to a 10.4% taxable yield for someone in the 33% federal marginal tax bracket. By contrast, the yield on taxable 30-year Treasury bonds stood at 4.96% on Wednesday.

Mutual fund managers and other institutional investors said the high yields demanded on the tobacco bonds in large part reflected the glut of those securities. Other states preceded California with tobacco bond sales, and more are expected to follow.

Because the bonds will be paid off by the handful of big tobacco firms, institutions lump all of the bonds as one issue regardless of the state that sells them. That limits the amount of the bonds that can be held by a single mutual fund.

“The market is choking on tobacco bonds,” said Mark McCray, a fund manager at Pimco Funds in Newport Beach. “Investors feel it’s very difficult to add more of the same risk” to their portfolios.

Joe Deane, a muni manager at Smith Barney funds in New York, said the difficulty in selling the California bonds also was a sign of investors’ jitters about the state’s finances in the face of a huge budget gap.

“Everybody’s taking a close look at the budget situation,” Deane said. A key issue for investors, he said, is whether California will borrow its way out of its budget deficit instead of addressing structural problems in revenue and spending.

The money raised in the tobacco bond sale is slated to help plug part of the budget gap. But McCray said the high yields required to sell the securities show that the marketplace regards the bonds as “a very expensive way to solve a budget problem.”

California’s credit rating already is among the lowest of the 50 states. Standard & Poor’s in December downgraded the state to “A” from “A-plus.”

Investors who own California muni bonds and bond mutual funds have seen prices of the securities fall modestly since October, as market interest rates on munis have risen. That followed three years of mostly declining yields and rising bond prices.

Fund managers say that much of the rise in muni yields is tracking a rebound in Treasury yields tied to expectations that the economy will improve in 2003, raising the cost of credit. Now, budget concerns are adding to munis’ upward trend.

No one expects California to default on its debt. But as investors perceive that a bond is even slightly riskier than competing securities, they typically demand higher yields.

Since the start of the year, another issue may be weighing on muni bond values: President Bush’s proposal to end taxation of corporate dividends, which could make some stocks more appealing to income-oriented investors, at munis’ expense.

“At the margin, that could make munis a little bit less attractive” to some investors, said Steven Permut, a muni fund manager at American Century funds in Mountain View, Calif.

State Treasurer Phil Angelides on Wednesday said Bush’s plan could force muni issuers to pay higher yields to lure investors. He said that could cost the state $17 billion over 10 years.

Still, Permut and other fund managers said California tax-free muni yields already are at high levels relative to Treasuries. That should make them appealing enough for many to hold on to the bonds or buy more -- especially if state income tax rates rise to close the budget gap.

Higher tax rates could drive more investors to seek out tax-exempt securities.