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California will pay heavily for bond issue

State's financial problems bring it a lower debt rating, and that means higher interest expenses.

May 20, 2001

By GREGORY ZUCKERMAN The Wall Street Journal

As if California didn't have enough headaches, the state's growing financial problems mean it will pay a steep price to sell a record bond issue that is designed to help deal with the state's energy crisis.

The recent downgrading of California's debt ratings have added to investors' concerns - and that likely will cost an extra $55 million or so annually in interest expenses on a planned $13.4 billion bond offering that will be issued by a department of the state of California.

The extra cost could go even higher if California's fiscal problems get worse by the time of the bond issue, planned for mid-August, because investors would expect an even better return to offset the higher risk the bonds would carry.

California is facing a cash crunch because it has spent more than $6 billion this year buying electricity on behalf of financially troubled utilities to limit blackouts that have threatened the state's economic well-being. That money has come out of the state's general fund, which is being depleted. Money from the bond sale would replenish that fund, with the aim of having enough money left over to pay for additional electricity purchases by the state in the summer and the fall.

"This is like watching a horror story unfold on the big screen," said Marilyn Cohen, the author of The Bond Bible and the president of Envision Capital, a Los Angeles investment firm. "The Orange County bankruptcy crisis was a tea party compared to this -- and we all thought that was bad."

In recent months, interest rates on long-term uninsured California state bonds outstanding have climbed about 0.45 percentage point relative to comparable bonds because of the growing energy difficulties, making it more expensive for California and municipalities around the state to get financing for all kinds of projects.

Anxious investors

Growing concerns about the state's financial condition have prompted both Moody's Investors Service and the Standard & Poor's Ratings Group to slash ratings on state of California bonds. Though neither agency has issued a rating yet on the planned bond issue, concerns about the state's fiscal condition - and about the whopping size of the deal - mean it will almost certainly have to pay a premium to attract investors.

"They're going to have to price it to the point that it attracts muni investors from all over the country," says David MacEwen, the head of municipal-bond investments at American Century Investments in Mountain View. "It's a huge deal, and a lot of the money may have to come from outside the muni market; it's not a pretty story."

The bonds, being sold by the California Department of Water Resources, will be backed by revenue from electric-utility bills it levies on consumers and businesses, rather than by the full faith and credit of the state. Revenue bonds typically pay a slightly higher interest rate, because they are backed by a specific revenue stream rather than the state's broader taxing authority; thus, they can be considered riskier.

On Tuesday, the state raised utility rates, but the increase isn't enough to pay the costs incurred to buy power. The bond issue will generate immediate cash to bridge that gap until long-term power contracts kick in and planned new power plants come into operation, expanding supplies. If the bond deal fails, it will be a major blow to the state.

There will likely be enough interest in the bonds to get the deal done, investors and analysts say. The muni market has seen issuance of more than $240 billion so far this year, and muni-bond funds, individual investors and insurance companies are already lining up to get a piece of the sale, which will be underwritten by J.P. Morgan, a unit of J.P. Morgan Chase.

In-state demand

Municipal bonds from California traditionally have greater demand than comparable bonds in the rest of the muni market. That is because the state is full of wealthy investors eager for the tax-free benefit of the bonds. "If you're a market participant, you can't afford not to examine it and consider it," says Mark McCray, municipal-bond portfolio manager for Pacific Investment.

But lately, prices on California bonds have been falling, sending yields - which move in the opposite direction - higher.

With investors beginning to clear out room in their portfolios for the big $13.4 billion bond deal in a few months, prices on other bonds from the state are hurting, making it more expensive for all kinds of municipalities to raise new money.

For example, the California Department of Water Resources had to boost the interest rate on $261 million of bonds it sold in late April by as much as 0.2 percentage point to get investors to buy the bonds, largely because the big $13.4 billion bond deal is looming, according to investors. That means the department is shelling out about $5 million in extra interest payments during the course of the 28-year deal.

While analysts say it is much too early to estimate the eventual interest rate on the bonds, investors say the bonds would likely have to sport rates about matching those Treasurys, even though the utility bonds will likely be tax free. That means the bonds could come out with a yield of about 5.5 percent for 30-year bonds, at current rates. If the state pays a third party to insure the bonds, the rate would likely drop to about 5.45 percent. By way of comparison, the average long-term top-rated municipal bond trades at a yield of 5.31 percent.

Taxed plus tax-free

Some of the bonds will likely be targeted to the taxable bond market, because the muni market isn't likely big enough to swallow the entire $13.4 billion size of the deal in one swoop. These taxable bonds will likely have to carry an even higher yield, perhaps above 7.5 percent.

On Thursday, California Treasurer Philip Angelides told investors in a teleconference that the state's first $8 billion of power purchase bonds will be tax-exempt, a smaller percentage of the total deal than previously announced.

Since the bond deal will be so big - it will be almost four times the size of the record holder for the biggest muni bond deal, a 1998 sale by the Long Island Power Authority - the state may have to pay even more to get all the bonds sold at one time.

"The deal is huge, it will definitely be harder to get done," MacEwen says.

Fears that California will have to return to the bond market to sell even more bonds to raise more money will also likely weigh on the deal, as may worries that consumer groups will challenge the interest payouts.

"That's a critical question - if this is the last deal for a while, or if there's another $5 billion to $10 billion coming in the near future," McCray says.

The expectation of further debt would likely damp the demand for this round, he added.

Before any bond deal can proceed -- and preferably before Aug. 13, the earliest time the transaction can take place -- the state will have to clear several hurdles. Details on the offering have yet to be formalized and rating agencies haven't had a chance to rate the bonds.

"We don't know diddly about the structure," says Cohen at Envision Capital. "Nobody has even put up a trial balloon to see, 'Gee, what would the market be able to absorb easily and smoothly? What kind of structure would the market find really palatable?' So right now there are lots of questions but no answers."

Investors expect the deal to be largely tax-exempt, but if California can't get tax-free status for the bonds, the state will have to pay a much higher interest rates to get investors interested.

The state will have to figure out a way to free the revenue from the recent rate increase to be dedicated to paying bondholders; but if creditors for bankrupt utility PG&E prevent the revenue from being allocated to the bonds, the bond sale could fall apart.

Register reporter James B. Kelleher and Reuters contributed to this story.

-- Martin Thompson (, May 20, 2001


It's the August start that's the killer here. By then the summer heat will slay it, dead in its tracks.

-- Wayward (, May 20, 2001.

All of the problems CA is having now, we predicted it long ago, here on Grassroots. It didn't take a nobel laureate in economics to put the clues together

-- Guy Daley (, May 20, 2001.

This article, to me, only signals the start--the seeds of panic will be growing day by day, now, methinks.

-- Uncle Fred (, May 20, 2001.

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