California debt rush

September 2, 2009

Talk about a comeback. After a bruising budget fight that forced it to issue IOUs, California plans to sell as much as $10.5 billion in short-term debt later this month.

A reach for yield should trump lingering doubts about the state’s prospects among the small and large investors who are expected to snap up the revenue anticipation notes.

But potential buyers should also be sure to have strong stomachs, as the Golden State remains anything but golden.

The timing for such a sale appears to be good. Confidence in California debt has improved greatly since the state passed its budget, and the minuscule return on most short-term debt means the expected 2.5 to 3 percent yields on the new RANs would give individual investors and mutual funds who invest in such debt a nice bump to their holdings.

RANs essentially borrow against future revenues and are very useful for plugging cash shortfalls, as California well knows — the state raised $5 billion last year and $7 billion in 2007 through these notes that mature in less than a year.

This year, the notes will help bring to an end the IOU saga that brought embarrassing national attention to the state’s fiscal mess, by repaying a loan from JPMorgan Chase that allowed the state to stop issuing the IOUs a month earlier than expected.

But estimating what California’s revenue will be is a tricky business. Just ask the state’s Controller, John Chiang, who is charged with reconciling the state’s estimates with reality on a monthly basis.

His reports over the last year have made for grim reading. Since December of last year, the state had to resolve a $61.7 billion budget deficit for a period of less than 1.5 fiscal years, Standard & Poor’s noted in a report on the state last month.

As the broader economy stabilizes and financial markets find firmer footing, the worst could be over for California. Still, there are lingering doubts about whether its revenue projections in the recently enacted budget are conservative enough.

Luckily for those considering buying the RAN notes, the Controller’s office will be releasing its next report on cash flows on September 10. The debt sale is currently slated for the week of September 21.

This will provide a glimpse into the state’s fortunes in August, the first month after legislators and the governor signed off on the new fiscal budget.

If revenues deteriorate at a faster-than-expected pace in the months ahead, then a replay of last year’s scramble could again be on the cards.

For investors tired of turmoil, a few percentage points of yield may not be worth it.

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