Budget Woes Don’t Faze Muni Bond Holders Yet

By late last week, Don Young had heard enough about the state’s budget woes. The 70-year-old Rancho Palos Verdes resident cashed out his investment in short-term California municipal bonds and put the money in U.S. Treasury securities instead.

“I was just kind of losing faith,” said the California native, referring to the Golden State’s deepening fiscal crisis. Though the state and most of its municipalities continue to pay their bills, Young decided his money would be safer in U.S. bonds.

So far, Young is the exception rather than the rule among California muni bond investors. Despite another cut in California’s credit rating Monday, tax-free bonds issued by the state and its thousands of municipalities are holding their value as most investors sit tight.

Bond dealers say there has been no rush to bail out of California muni bonds in recent weeks, even as state coffers have run dry, forcing Sacramento to issue IOUs for the first time since the Depression. Indeed, yields on most California muni bonds have fallen in recent weeks, a sign of healthy investor demand.

The majority of bond owners still believe the state’s fiscal problems won’t affect bond interest payments, analysts say. And though the bond-rating firm Moody’s Investors Service late Monday cut the state’s rating to “Aa” from “Aa1,” that move was expected and shouldn’t cause adverse investor reaction today, experts say.

Still, bond dealers are worried about investors such as Don Young and the potential toll on investor psychology if the state’s budget crisis drags on much longer. Already, some California bond mutual funds say they’re getting more calls from investors concerned about the safety of the bonds.

“It definitely has become more of a topic of conversation for our phone reps,” said David Hamlin, manager of the $800-million Vanguard California Insured Tax-Free fund in Valley Forge, Pa.

Though virtually no one expects the state to miss a bond payment, there is less certainty about some of the California cities, counties and other municipalities that issue bonds independently. They are likely to face their own budget crises as state aid is slashed.

“I think that’s where the bigger problems will be,” said Claire Cohen, bond analyst at Fitch Investors Service in New York.

Yet small investors--who individually or through mutual funds own a substantial amount of the estimated $130 billion in California muni bonds outstanding--were much more nervous about the bonds earlier this year.

Some types of bonds, such as so-called Mello-Roos issues used to fund local real estate development, became difficult to sell last winter as investors feared widespread defaults.

But when the expected wave of defaults failed to materialize in the spring, most categories of California muni bonds quickly recovered.

Today, experts say investors’ relative calm also is a function of the decline in interest rates on all types of bonds in recent weeks, as the economy has appeared to weaken. When market rates are going down, bond investors are much more inclined to hang on to their higher-yielding securities.

“In this environment, people are very reluctant to sell any bonds,” Hamlin said. And because interest on California munis is exempt from both federal and state income tax if the bond owner is a state resident, the bonds can provide lucrative returns compared to virtually all other fixed-income investments.

Even so, some bond pros worry that too many California muni investors don’t know enough about the bonds they own and the health of the issuers. Though the state ultimately can raise taxes if necessary to pay interest on its general obligation bonds, some smaller issuers--such as school districts--may face a far tougher time meeting their obligations if state aid is decimated.

David MacEwen, a muni portfolio manager at Benham Capital in Mountain View, fears that individuals own the bulk of bonds issued in recent years by the state’s weakest municipalities--the ones most at risk in the current budget crisis.

“Small investors tend to go for the highest yields, and that’s where yield has been--in the lesser credits,” he said.

* MAIN STORY, A1

Bond Funds Post Strong Returns

Falling market interest rates helped boost the value of existing bonds in the second quarter, producing hefty returns for bond mutual fund share owners. Here are average total returns for key fund categories. Total return measures interest earned plus or minus the change in the funds’ share prices in each period.

Average total return: Fund category 2nd Qtr. First half 12 mos. World bonds,long-term +4.81% +2.19% +17.24% General muni bonds,long term +4.15% +4.29% +12.11% High-quality corporate bonds, long term +3.99% +2.40% +14.25% Mixed bonds +3.97% +4.17% +15.73% GNMA bonds +3.93% +2.67% +13.00% U.S. govt. +3.82% +1.79% +13.090% bonds,long term High-quality corporate bonds, 5- to 10-yr. +3.78% +2.62% +13.16% U.S. govt. bonds, +3.76% +2.06% +12.79% 5- to 10-yr. Junk corporate bonds +3.03% +11.36% +24.61% U.S. govt. bonds, +2.94% +2.42% +10.15% 1- to 5-yr. High-quality corporate bonds, 1- to 5-yr. +2.77% +2.83% +10.25% World bonds, +2.60% +3.27% +7.72% short-term Adjustable-rate +2.03% +2.91% +8.82% mortgages Money market +0.85% +1.81% +4.41% funds

Source: Lipper Analytical Services Inc.