State’s Counties, Schools to Find Out How Costly O.C. Debacle Is

California’s counties and school districts will soon find out whether Orange County’s fiscal debacle has truly poisoned the money well.

As much as $8 billion in short-term notes will be floated by municipalities over the next month or so, an annual rite as local governments raise cash to tide them over until future tax payments arrive.

In years past, these short-term notes have generally been snapped up by institutional and individual investors, who considered the debt among the safest paper they could own. It matured in just 12 or 13 months, after all, and the interest was exempt from state and federal income tax.

But Orange County’s bankruptcy has changed many investors’ benign approach to short-term muni debt in California.

First came the shocker that Orange County might simply walk away from certain of its note obligations, arguing that they were illegal to begin with.

Even more noxious to many investors, however, was a seeming technicality: In February, Orange County opted, with Bankruptcy Court approval, to forgo the normal set-aside of reserves to cover short-term notes maturing this July.

The county said it needed the money for other purposes in the near term. But to note holders, the abrogation of the set-aside agreement raised fears that other California note issuers might also begin to look upon standard set-aside requirements as a “maybe we will, maybe we won’t� proposition.

That may seem a grossly exaggerated concern, of course. The vast majority of municipal borrowers obviously have nothing to gain by angering their investor-lenders. And Wall Street knows that.

But one powerful group of investors--mutual funds--have nonetheless been engaged in a full-court press on this issue. Several fund companies, including Alliance, Benham Group and Franklin Resources, last week fired off a letter to Gov. Pete Wilson and other state politicians, warning that fallout from Orange County’s decisions could shake the muni note market in June.

Some fund companies, like Benham, have said flat-out that they don’t think they’ll buy any short-term notes floated by California issuers this spring unless the notes carry some kind of third-party guarantee--private insurance or “letter of credit� backing by a major bank. In either case, the cost of that guarantee would be borne by the municipality and ultimately by its taxpayers.

Other fund managers have been less specific about what they may or may not buy. “A letter of credit would take care of it for us,� said Robert Schubert, senior portfolio manager for Franklin’s California tax-free money market fund. Without a letter of credit, it becomes “iffy,� he said.

*

The cynical view of the fund industry’s threats is that fund managers are simply interested in extracting the highest possible interest rate from borrowers, for the benefit of fund investors.

The funds, however, claim this isn’t just a typical issuer-investor poker game. They say they have a more basic concern, which is obeying Securities and Exchange Commission rules requiring that funds buy only the highest-rated securities for money funds. Orange County’s abrogation of the set-aside clause, the funds argue, has created a major element of doubt about all California notes.

Therefore, to avoid potential legal problems down the road--however remote the chances--some fund firms are balking at buying California notes as if it was business as usual.

But that begs another question: What will the funds use to replace maturing notes bought a year ago? Some fund execs concede that could be a problem, but a minor one. Fund tracker IBC/Donoghue says such notes make up just 18% of the typical California tax-free money fund. The majority of assets--59% on average--are in much shorter-term securities called variable-rate demand notes, floating rate securities that municipalities use as cash-management tools.

So far this year, funds’ concentration of assets in those very short-term securities has worked to their advantage. Short-term muni yields, like taxable money market yields, are higher now than they were in January, a function of the market’s expectations that the Federal Reserve Board isn’t yet ready to loosen credit.

The average single-state muni fund yields about 3.79% now (that’s a 30-day compound yield), and California-only funds have tracked that national average closely. Higher-tax-bracket investors will find that a 3.79% tax-free yield is equivalent to a taxable money fund yield above the 5.67% average that those funds now pay.

But the risk for California tax-free money funds that pass on the upcoming notes altogether, thus giving up the chance to lock in the expected 4%-plus, one-year yields, is that they could suffer later in the year if the Fed begins to ease credit, pushing all short-term interest rates (and probably longer-term rates) down.

In that case, those funds that are heavily concentrated in very short-term securities could see their yields decline more sharply than funds that locked in some of the June notes.

However this game of chicken plays out, it could spell opportunity for investors who have the wherewithal to invest directly in short-term California notes. Though that generally requires at least $25,000 minimum and a broker’s help, high-tax-bracket investors who believe that interest rates are definitely headed lower over the next year should be on the lookout for lucrative muni note deals in coming weeks. The borrowers’ pain can be your gain.

* SETTLEMENT TALKS

Orange County, Merrill Lynch held secret New York meeting. A3

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Higher Returns on Short-Term Munis

Yields on money market funds that invest in short-term tax-free municipal securities have risen this year even as longer-term yields have fallen. Average 30-day compound yields for state-specific money funds:

May 1995: 3.79%

What’s a Tax-Free Yield Worth?

For a California taxpayer in the 37.4% combined state and federal tax bracket (taxable income of between $94,251 and $143,600) a 3.79% tax-free yield is worth the same as a 6.05% fully taxable yield. By contrast, the average taxable money fund now yields 5.67%.

Source: IBC / Donogue