What Municipal Bond Buyers Should Learn from Bridgeport
“California isn’t New England.” How many times have Golden State investors recited that statement (or prayer) since the recession hit?
The chief concern until recently has been over real estate prices. Now, the worries are shifting to an investment just as close to many folks’ hearts: tax-exempt municipal bonds.
With last week’s bankruptcy filing of Connecticut’s largest city, Bridgeport, people who own the bonds of other economically stressed cities, counties and states got a wake-up call. Muni bonds, some people are finally noticing, aren’t the same as U.S. Treasury bonds after all.
In California, still reeling from recession, there nonetheless remains a strong feeling that state and local bonds are universally safe from real trouble. And because interest on the bonds is exempt from both federal and state income taxes for state residents, the high muni yields continue to lure many investors.
Even so, California investors aren’t so sanguine as they seem on first blush. They’ve been demanding ever-higher yields on those state bonds perceived to pose the greatest risk--namely the so-called Mello-Roos bonds often used to finance land development.
In short, the market may be flashing an early-warning signal here about California muni bonds in general.
Mello-Roos bonds, named for the state legislators who conceived the concept in 1982, are sold to raise money to install basic infrastructure (such as sewer and water lines) in planned housing developments. The bonds probably made up about 10% of all California muni bonds issued last year, figures Zane Mann, editor of the California Municipal Bond Advisor newsletter in Palm Springs.
So far, Mann says, “We have yet to have a single Mello-Roos default in California.” But because a housing developer is responsible for paying interest on the bonds until homes are actually built on the property, the risk may be growing: If struggling developers are unable to build and sell homes on their semi-developed lots, they may be unable to make their interest payments.
Professional investors know this. So when a Mello-Roos bond issue comes to market these days, the yield can be steep indeed.
“A year ago people weren’t doing their homework on the state’s muni bonds--they were counting on the California real estate market to go on booming forever,” says Steven Permut, who runs the Benham California High-Yield bond mutual fund, which owns only California bonds.
No matter how weak a land developer might have been viewed a year ago, the difference between yields on low-quality Mello-Roos bonds and high-quality ones had been a mere 0.05 to 0.10 percentage points, Permut says.
Now, a riskier bond will have to yield as much as 0.75 points above rates on high-quality bonds to sell, he says.
For an uninformed individual investor, that can be a dangerously alluring spread. If someone offers you two muni bonds, one paying 8% and the other 8.75%, you will certainly be tempted to go for the higher yield--figuring some government entity will protect you in the end.
But hundreds of investors who bought such development bonds in Colorado have found themselves in soured deals, Mann notes.
A longtime observer of the California muni bond market, Mann is no doomsayer. He doesn’t believe that the state or the vast majority of its cities, counties or other bond-issuing authorities will end up in serious financial straits from the recession.
Historically, muni bond defaults have been minuscule nationwide, Mann notes, and he figures that won’t change. Even now, “The rate of default is not accelerating, despite what’s going on with the economy,” he says.
Moody’s Investors Service, one of the major bond-rating agencies, also insists that California investors generally needn’t worry about the future of their state or local muni bonds. “The company feels really good about the long-term bond ratings for localities in California,” says David Ambler, vice president for Moody’s in San Francisco.
“This state still is a large, diverse economy that handles recessions well,” he says. Despite the state’s growing budget deficit, Ambler notes that California’s size is an inherent advantage. “Other states don’t have the resources that California has to solve its problems,” he says. You can read that as: Other states don’t have the taxing capacity that California has, if things get tough.
Still, experts agree that the market is sending up a flare on the Mello-Roos bonds. The warning is, you can no longer just buy any California muni bond and sleep well at night.
Mann believes that “in the darkest, worst-case scenario, wherein the recession is much more severe and lasts much longer than anyone presently foresees,” muni bond defaults still would total less than 2% of outstanding issues nationwide, and by proxy, in California as well.
But the defaults would occur almost exclusively among “private-purpose” bonds, such as those under the Mello-Roos tag, rather than among bonds fully backed by states or cities, Mann says.
Mello-Roos bonds often go unrated--that is, a private credit agency doesn’t judge their credit-worthiness. Thus, the simplest way for individuals to avoid trouble is to avoid investing directly in any non-rated muni bond today, Mann advises.
What if you’re a muni bond mutual fund owner? Some funds do own non-rated bonds, of course--particularly the funds that advertise themselves as “high yield.” But fund managers have the resources and time to make judgments on which non-rated bonds are worth the risk. Most individuals can’t do that kind of detailed analysis (and neither can their brokers).
What’s more, even some high-yield muni fund managers say they’re far less willing to go out on a limb for Mello-Roos and other such non-rated bonds today. Permut, for example, says only 28% of his $60-million portfolio is invested in non-rated California bonds now, down from 60% last year.
The moral: Safety is trendy again, and the wise investor doesn’t fight the trend.
Those Tempting Muni Yields California investors who buy bonds issued by the state or its cities or counties pay neither federal nor state tax on the interest. What California bonds of all sorts yield now, and what top-tax-bracket investors (that’s a 37.4% combined federal/state bracket) must earn on a taxable CD or bond to match those yields:
Calif. muni Yield Taxable-equivalent bond term range yield, top tax rate 1 year 4.00%-5.00% 6.40%-8.00% 5 year 5.40%-6.00% 8.60%-9.60% 10 year 6.20%-7.00% 9.90%-11.20% 20-30 yr. 6.50%-8.75% 10.40%-14.00%
Still the Golden State Yields on California state general obligation bonds still are lower than yields on similar bonds of most other states--a measure of California’s perceived financial strength.
State genl. oblig. bonds Moody’s Recent (20-year term) rating yield Georgia Aaa 6.66% New Jersey Aaa 6.71% California Aaa 6.71% Virginia Aaa 6.81% Connecticut Aa 6.91% Illinois Aaa 6.91% New York A 7.36% Massachusetts Baa 7.71%
Source: Muller Data Corp./The Bond Buyer
