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.
