Dec. 28 (Bloomberg) -- The Treasury’s $35 billion sale of five-year notes was a “stinker” and underscores the trouble facing U.S. economic policy makers, Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., told CNBC in an interview.

The auction, one of three note offerings this week that total $99 billion, attracted the lowest demand at a five-year securities sale in six months. It drew a yield of 2.149 percent, higher than the 2.133 percent forecast in a Bloomberg News survey of nine of the Federal Reserve’s 18 primary dealers. Gross said municipal bonds are outshining U.S. debt.

“That the U.S. Treasury has to come with $100 billion in the last week of the year, you know, it shows to a certain extent the corner that they’ve painted themselves into,” Newport Beach, California-based Gross said in the interview today. “They have to fund $1.25 trillion to $1.5 trillion deficits, and it simply shows the problems that the U.S. is encountering in terms of their deficit.”

Gross has been buying municipal bonds because their yields are attractive on a risk-reward basis, he said.

“Municipal bond yields are much higher than Treasuries and, in many cases, corporate bonds,” Gross said. A 7 percent yield on California bonds provides “a decent return relative to the admittedly higher risk these days,” he said.

While Illinois is probably “in the worst shape,” it and other states are unlikely to default because of assistance that’s likely to come from the federal government, he said. Gross said he was avoiding Illinois.

--Editors: Greg Storey, Paul Cox

To contact the reporter on this story: Daniel Kruger in New York at dkruger1@bloomberg.net

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net