Nervous Bondholders : Recession-Weary Local Governments Threaten Stability of Muni Market

For the many thousands of investors who own California municipal bonds, watching the state’s economic slide in recent years has been like viewing an oncoming storm: You see it and hear it long before any rain falls on you.

But after three years of deep budget cuts--the result of fleeing jobs, falling real estate prices and devastating drought--the ability of the state’s myriad local government units to pay their debts now is a topic of serious concern among financial pros.

With further budget strife looming, “we’re at the point where local officials have to say, ‘We’re either going to reduce services or pay our bondholders,’ ” says Steve Juarez, executive director of the California Debt Advisory Commission, the watchdog state agency for public debt. “It’s a horrible choice that local governments have to face.”

It’s not a pretty choice for small investors, either. Through individual bond holdings and mutual funds, yield-hungry individuals have become the dominant owners of muni bonds nationwide since the mid-’80s, far surpassing institutional muni ownership. That is particularly true in California.

To be sure, most experts believe that the vast majority of cities, counties, school districts and other government entities in California will find a way to pay their creditors, who for decades have loaned the money used to build schools, sewers and other projects deemed necessary for the public good.

The alternative of default--an event defined as the interruption of interest payments owed bondholders--is for local governments the equivalent of personal bankruptcy for individuals: A ruinous blotch on your reputation, and one that stays with you for many years.

Still, with an estimated $130 billion in tax-exempt muni bonds outstanding from literally thousands of state and local issuers, the California muni market is so huge that even a small percentage of defaults would be significant in dollars.

And in fact, trouble is already on the rise. Zane Mann, publisher of the California Municipal Bond Advisor newsletter in Palm Springs and one of the few independent analysts monitoring the mammoth muni market, says four California bond issues worth $61 million defaulted last year.

This year, Mann projects $100 million in defaults. Over the past month alone, he says, the number of shaky California bond issues he tracks has jumped from 12 to 20. Those are issues which haven’t defaulted but whose future ability to pay is suspect, Mann says.

Perhaps more important, he says, is the potential negative effect on the market value of all sorts of California bonds if buyers become increasingly gun-shy about the stability of issuers. While the main allure of muni bonds won’t change--interest payments exempt from federal and state income tax--the underlying price of the bonds also matters.

If a muni bond becomes a tough sell, and you’re one of the unfortunate owners who must sell for one reason or another, your $1,000 bond may fetch only $800 or $900--or less.

How concerned should individual California bond owners be? Your chances of owning a bond headed for default admittedly are small. Nevertheless, Mann advises all muni investors to know exactly what they own, and the prospects for the issuers’ financial health.

“The day when you could just buy a (California) muni bond portfolio, put it in a box and forget it is gone,” Mann says.

Here’s a look at some key themes affecting the California muni market, and the potential trouble spots they’re creating:

* Prop. 13: Trickle-down works both ways. When Proposition 13 was approved in 1978, California government financing changed dramatically. With limited ability to raise local taxes, California’s cities, counties and school districts became dependent on state dollars to fund their growth.

That worked fine in the boom years. But now, facing the worst economic slump since the 1930s, the state has run out of tricks--and revenue. That has forced Sacramento to slash funding to local governments. And because they’re still limited by Prop. 13, local entities suddenly have nowhere to turn for cash. Thus their decision: What to cut from the budget?

The relatively easy cuts were made last year, says CDAC’s Juarez, and the more painful cuts will come during the fiscal year beginning July 1. Gov. Pete Wilson has projected an 8.5% cut in the next state budget; many local governments will suffer in kind.

That is why muni experts advise investors to be extremely vigilant this year. If local officials are going to decide that they can’t pay their creditors, it will happen with the new round of budget cuts. “The choice they have is whether to honor contractual obligations or societal obligations,” Juarez says.

At the state level, no one is worried that the governor or Legislature will propose walking away from California general obligation bonds, the most visible form of state debt. Still, the “quality” rating given those bonds could be cut again, depressing their value.

Moody’s Investors Service said last week that its current ‘AA’ rating on California general obligation bonds remains “under pressure” because of the state’s deteriorating financial condition. A drop to ‘A’ would be a painful blow.

* Counties are among the worst-hit. “County governments are most vulnerable to state funding cutbacks because they have the least ability to raise revenue, while at the same time they are the social-services provider of last resort,” says Steven Zimmermann at bond-rating agency Standard & Poor’s.

Los Angeles County supervisors, for example, concede that they as yet have no idea how to cope with a projected $845-million deficit in the next fiscal year.

(Cities, by contrast, can raise parking fees and other small charges to help meet budget.)

Still, few muni pros worry that Los Angeles or any other large counties will actually default on their debts. More likely, social services will be slashed further.

Even so, the market value of county bonds in general could slump if budget woes worsen and investors shy away. If you’re unwilling to hold county-issued debt to maturity, be aware that you might get a lousy price if forced to sell such bonds over the next year.

* COPs remain the riskiest credits. COPs, or certificates of participation, have been heavily issued by many California school districts, counties and other special districts since 1980. The problem is that many of the investors who have bought these securities thought they bought bonds. Not so.

Both bonds and COPs serve the same purpose--generally, to fund new public works projects. But a bond requires a pledge of new tax money by the issuer to make interest payments, if necessary. A COP’s interest payments are essentially funded at the issuer’s discretion. That apparent loophole has muni pros afraid of stressed COP issuers walking away.

Moreover, a landmark COP dispute in Brevard County, Fla., has greatly increased investor angst. Faced with local voters’ anger over spending on a new county facility, Brevard supervisors will allow voters to decide in March whether to uphold or renege on the bonds issued to pay for the complex.

Though Brevard is definitely a special case, muni experts warn that California COPs probably are the securities most at risk when push comes to shove in local government units’ budget process.

“These types of financing were not part of the picture in previous (recessions),” so there’s no history to indicate how secure they are, says Larry Troutman, manager of the Dreyfus California Tax-Exempt bond mutual fund.

How can you be sure about your COPs? Zane Mann figures the safest COPs are those used to finance buildings or projects “so essential that the school board or city council would be hard-pressed to say, ‘We’ve thought it over, and we’re not going to make our payments.’ ” A jail, for example, is essential. A golf course isn’t.

(The issue of essentiality also is why the safest California muni bonds are those that fund services such as water and power. They have become the most popular bonds for risk-averse investors.)

In general, the smaller the COP issuer, the more concerned you should be, says Reid Smith, manager of the Vanguard California Insured Tax-Exempt bond fund.

“We’re very negative on small-district COPs. We feel it’s much easier for a small district to walk away from their obligations” than for larger jurisdictions to do so.

* Mello-Roos bonds: Problems, but not disaster. Mello-Roos bonds have been used extensively to fund new residential developments, providing the infrastructure--such as sewers--upon which a development is built. The taxes to support the bonds are supposed to come from people who buy the homes.

The problem since the California real estate market crashed three years ago is that some developments were never built after the developer spent the infrastructure money. So the question becomes, who will pay for the bonds?

So far, defaults have been few. But of the 20 troubled bonds that Zane Mann now is tracking, most are Mello-Roos issues, he says.

The good news is that of the 300-some Mello-Roos issues outstanding, the good credits appear to far outnumber the bad.

A report due this week from a private study group is expected to show that most developers responsible for these issues are in decent financial health, and are able to make interest. Fear of Mello-Roos bonds “has definitely been blown out of proportion,” says Peter Placey, one of the study’s authors.

* What you should do: Ask questions. If you were sold individual muni bonds by a broker, go back to that person and ask for a thorough review of what you own, and the health of each issuer. Don’t just assume the broker knows what’s in your portfolio, especially if the bonds have been there awhile.

An alternative, says Zane Mann, is to go directly to the bond’s trustee, the financial entity responsible for collecting interest. (The name is on the bonds.)

The point is, don’t be afraid to ask questions, Mann says. It’s your money, and you’re entitled to know how safe it is.

*

California Bond Funds: A Sampling

Here are performance figures for a sampling of California muni bond mutual funds, including results in January, in 1992, and the five years ended Dec. 31. Total investment return includes interest earned plus or minus any change in principal value. Also shown is the annualized yield on each fund over the past 12 months.

Funds Owning Non-Insured Bonds

Total investment return: 12-mo. Fund Jan. 1992 5-year yield Franklin Cal. Tax Free +1.09% +9.29% +57.3% 6.6% Putnam Cal. Tax-Exempt +1.21% +8.98% +60.4% 6.8% Fidelity Cal. High-Yield +1.19% +8.72% +57.0% 6.2% USAA Tax-Exempt Cal. +1.13% +8.27% NA 5.9% Kemper Tax-Free Cal. +1.15% +8.24% +54.2% 5.8% Benham Tax-Free Cal. Long +1.01% +8.13% +56.2% 5.9% Merrill Cal. Muni Bond +0.85% +7.94% +51.9% 5.6% Dean Witter Cal. Tax Free +0.95% +7.83% +53.0% 5.3% Dreyfus Cal. Tax-Exempt +1.01% +6.65% +49.6% 5.9%

Funds Owning Insured Bonds

Total investment return: 12-mo. Fund Jan. 1992 5-year yield Vanguard Cal. Insured +1.03% +9.34% +59.3% 5.7% Nuveen Cal. Insured +1.04% +9.34% +59.3% 5.6% Fidelity Cal. Insured +1.15% +9.15% +57.4% 5.7% Franklin Cal. Insured +1.34% +8.56% +57.8% 5.9% Average California fund +1.05% +8.37% +56.0% 5.9% General municipal funds +1.12% +8.71% +57.3% 5.8%

Source: Lipper Analytical Services Inc.