State sours on auction bond sales

California, the biggest borrower in the municipal bond market, will replace $1.25 billion of so-called auction-rate bonds with traditional debt after a series of auction failures nationwide sent rates soaring.

The state will convert $400 million of auction-rate general obligation bonds sold in 2003 and $500 million of power revenue bonds and $350 million of water bonds sold in 2002, debt manager Paul Rosenstiel said Thursday. The bond sales will occur within months, he said.

“We plan to redeem these as soon as we can so that we are out of auctions,” he said.

Auction-rate bonds are floating-rate securities. The interest paid by the borrower is reset every seven to 35 days.

The bonds have allowed issuers to pay lower rates in recent years than they would have by selling conventional long-term bonds.

But the credit crunch has caused many lenders and investors to pull back from the auction-rate market. When there aren’t enough bidders at the auctions the rates on the securities can rise sharply. In some cases in recent weeks issuers have been forced to pay double-digit rates.

Rates on auction-rate bonds backed by California’s general fund reset to as high as 6% on Feb. 14 from 3.4% on Jan. 10, costing the state $252,777 in added interest costs.

“There are people who are taking advantage of the situation to try to get very high interest rates,” Rosenstiel said.

Some auctions have failed altogether because of a lack of buyers, but even in cases where the sales have succeeded the result has been high rates that are a drain on issuers.

The Internal Revenue Service on Tuesday said it planned to issue new rules making it easier for local governments to convert auction bonds to lower-cost debt.