For muni bonds, some financial advisors look outside California
California and its local governments have long counted on a large captive audience for their debt: Many of the buyers are high-income individual investors who live here and find the federal and state tax exemption on California municipal bond interest too attractive to pass up.
This has been one case where having most of your eggs -- or at least your bond eggs -- in one basket seemed defensible. After all, municipal bond defaults have always been rare events.
They still may be relatively rare for a long time to come. Even so, after years of fiscal tumult in the state, financial advisors to some of California’s well-heeled investors have a very different attitude toward muni bonds today than they did, say, a decade ago.
Most high-income clients at Hokanson Associates, a wealth manager in Solana Beach, now have no more than half of their muni bond portfolios in California issues, says company founder Neil Hokanson.
The rest is spread among muni bonds of issuers outside California -- typically in what are known as unlimited-tax general obligation bonds, whereby the issuer pledges to raise taxes as high as necessary to protect payments to debt holders.
Diversification into non-California munis has a cost, Hokanson concedes. Golden State investors must pay California’s steep income tax (as high as 10.55%) on interest earned on out-of-state muni bonds. And yields on bonds of financially healthier muni issuers naturally are lower than what can be earned on the debt of California itself, which has the poorest credit rating of any state.
But Hokanson, whose firm oversees about $350 million, says his decision a few years ago to diversify into out-of-state munis fits with what he says is clients’ No. 1 concern these days. “They say, ‘We’re more worried about losing money than not making money.’ ”
Let me say right here: I am not about to suggest that the California muni market faces some immediate calamity, or even eventual calamity. Plenty of investors have been doing quite well with their California munis (state and local issues) for years, in the face of what have been increasingly dire forecasts about some issuers’ ability to pay.
The more dire the forecasts, generally, the higher the interest rates investors demand. The state’s next big test of that demand will come next week, when Treasurer Bill Lockyer will use a network of brokerages to sell $2 billion in general obligation bonds to fund voter-approved infrastructure projects.
I’ll hazard a guess that, five years from now, the state and the vast majority of cities, counties, school districts and other bond issuers in California still will be paying bond investors in full and on time.
Nonetheless, if there ever was a time for California muni investors to take a close look at what they own, this is it.
Why? First, there is no minimizing the challenge government units face from yawning budget gaps, depressed property values, huge long-term pension liabilities for public workers and doubts about the economy’s ability to produce badly needed, tax-revenue-generating jobs in the private sector.
These are national issues, not just California issues, of course. But they are as serious here as anywhere.
Second, if interest rates rise across the board in the next few years, for whatever reason, outstanding fixed-rate bonds are likely to be devalued. If you own individual muni bonds that you worry would be difficult to sell in today’s market, having to sell them in a time of higher rates could be much more problematic.
If you’re trying to evaluate your comfort level with California muni bonds, start with these three questions:
Did you buy bonds for the wrong reasons? Let’s face up to this muni market reality: Most people buy what a broker sold them, not what they picked out on their own. That’s why many individuals end up with a lot of bonds from small government issuers or agencies, of which there are thousands in California.
Marilyn Cohen, head of money manager Envision Capital Management in Los Angeles, says one new client came to her recently with a bond portfolio that encompassed 67 different California issues.
“Some of these issuers haven’t even put out financial statements since 2007,” Cohen said.
If California has entered an extended period of fiscal stress, the time to identify high-risk bond issuers is now. If the only thing you know about an individual bond is that it pays a lucrative tax-free yield, chances are you don’t know enough.
Want some objective advice on munis? Consider a subscription to the independent California Municipal Bond Advisor newsletter, which focuses solely on in-state bonds.
What does bond diversification mean to you? The double tax exemption on California muni interest has given many investors all the justification they need to rely exclusively on in-state munis for the bond portion of their portfolios.
Certainly, if you own a California muni bond mutual fund you’ve got plenty of diversification within the state.
But that’s no longer enough for financial advisors such as Hokanson and Cohen. “What the credit crisis has taught me is that anything can happen,” Cohen says.
She has moved 15% to 20% of many California bond clients’ portfolios into munis of other states -- Minnesota and Tennessee, for example, as well as Texas school bonds guaranteed by a fund that state has operated since 1854. California investors still get the federal tax exemption on out-of-state muni interest, but no state tax exemption.
The best reason I can think of to diversify into out-of-state munis is the risk of a massive earthquake. (Think Haiti, Chile.) If a 9.0 rocks the San Andreas, the devastation could immediately extend to local government finances. No doubt, everyone would assume Uncle Sam would ride to the rescue. We can only hope.
Some wealth managers also have been steering investors to think about shifting some of their muni assets into fully taxable corporate bonds, or mutual funds that own corporate securities.
There’s a very good case to be made that the finances of many multinational companies now are in far better shape than those of many state and local governments.
After the deep recession, “Companies have gone through the wringer in ways that governments have yet to,” said Michael Aronstein, chief investment strategist at Oscar Gruss & Son in New York.
Are you focused on the right risk with munis? Let’s just assume that most California muni bond issuers will find a way to make their debt payments. Your major risk, then, isn’t default. Rather, it’s what Wall Street refers to as “headline risk”: the chance that negative news about state or local governments’ fiscal situations will cause the market value of your muni bonds to decline (and therefore the yields for new buyers to rise).
Jason Thomas, chief investment officer at wealth manager Aspiriant in Los Angeles, says the firm began to move California clients from 100% in-state muni bonds to national muni portfolios in 2008.
“We were concerned about volatility, not an issue of getting paid back,” he said. “People need a fuller perspective on risk.”
Many owners of individual muni bonds will say they intend to hold their securities to maturity, and so they don’t care about short-term price fluctuations. “Buy and hold” may have been discredited in the stock market, but it seems to be alive and well in the bond market.
If there’s any chance you’ll have to sell your bonds before they mature, volatility risk is something you need to consider.
Joel Framson, a principal at Silver Oak Wealth Advisors in Los Angeles, says the potential for more turmoil in the California muni market, including the risk of further credit downgrades by ratings firms, is a key issue that keeps him out of munis in favor of high-quality corporate securities.
“What I don’t want,” he said, “is to have a conversation with a client a year from now where the [muni] portfolio has just dropped 10% because of a ratings cut.”
