Watchword for Muni Bonds Is Caution

The number of troubled California municipal bonds is rising as the state’s economic malaise wears on, a new study shows.

While not unexpected, the data nonetheless provides another wake-up call for the many thousands of Californians who hold tax-exempt muni bonds directly: Better know what you own, because defaults are likely to be more commonplace than less over the next 12 months.

The study released Tuesday by California Municipal Bond Advisor, a small Palm Springs-based newsletter, shows:

* A total of 41 California bond issues worth $740 million are on the newsletter’s Watchlist, up from 20 in January. Watchlist status means the issuer is experiencing financial difficulty, though payments to bondholders continue to be made.

* Of the 41, 19 are so-called Mello-Roos bonds used to finance real estate development at the local level. The 19 issues are worth $337 million, representing 8.5% of all outstanding Mello-Roos bonds in California--a rather high percentage that may take some muni-market pros by surprise.

* The rest of the Watchlist bonds are mostly “1915 Act” issues, which like Mello-Roos bonds have financed property development, usually in an end-run around Proposition 13 tax restrictions.

* Five of the 41 issues, worth $80 million, are in real danger of default, says Gavin Murphy, the newsletter’s editor. All five are bonds on property now in foreclosure. Whether the bondholders get their next payment may depend on the cash raised in foreclosure sales or on a bailout of the issuer.

Murphy’s Watchlist, which he painstakingly compiled with untold numbers of phone calls to bond issuers, trustees and local officials across the state, is not meant to be all-inclusive, he admits. But his data is sought by bond traders and mutual fund managers because there are so few independent information sources on the mammoth California muni market.

Murphy notes that, even with the rise in problem bonds, they are a tiny percentage of the $130 billion in muni issues outstanding from state, county, city and special-district issuers in California.

And it is no surprise that real estate bonds are in the worst shape, given the crash in residential and commercial property values in the past three years.

Mello-Roos bonds, for example, typically were issued to pay for sewers and roads in planned housing or commercial developments. The developer makes bond payments until property is built and occupied, at which time the property owners take over payments. But if the developer has gone bust in the real estate crunch, there may be no property owners--or not enough--to pay bondholders.

If the property ultimately is sold in foreclosure, and the price fetched is high enough to make the bondholders whole, nobody gets hurt. But that is the bone-jarring phase the California muni market is just now entering: We will see whether real estate bond issues were done with enough intelligence to allow for sinking property values.

With the troubled muni numbers Murphy has collected thus far, he and his publisher, Zane Mann, are sticking with their forecast of $100 million in outright muni defaults this year, up from $61 million in 1992. So far, only one default has occurred: a $16.5-million issue of Simi Valley housing bonds.

If you are unlucky enough to own an individual bond that is at risk of default, chances are the bond’s price has already cratered. If you have held on this long, some muni experts say you may as well stay put, taking your chances on a decent resolution of the issuer’s problem rather than selling out at fire-sale prices to crafty bond brokers (who, by definition, are not going to give you a good deal).

But Mann notes that although the bond fallout from the real estate crash has mostly been expected, there is another huge shoe yet to drop: the state’s austerity budget for the fiscal year beginning July 1, which will slash funding to cities, counties and other municipalities. The hard financial choices for many local bond issuers have not even begun.

“There’s a pretty strong perception in this market that things are going to get worse before they get better,” says Jeremy Ragus, who manages the $315-million Scudder California Tax-Free bond fund.

Thus, most professional muni investors, such as mutual funds, remain exceedingly cautious about what they will own. Many want only California bonds that are privately insured. If the issuer gets into trouble, the insurer guarantees the payments.

Insurance is only as good as the insurer, of course. But many bond buyers seem to trust the strength of major muni bond insurers more than local elected officials’ promises to pay. MBIA Inc., one of the nation’s largest private bond insurers, calculates that 48% of the $13.5 billion in California muni bonds issued so far this year are privately insured, up from 43% in 1992 and 25% in 1991.

You give up some yield when you buy an insured bond--but not much. Typically today, a long-term California bond that would yield 6% without insurance yields 5.8% with it. Insurer competition for California business is keeping premiums low, allowing greater returns to bond buyers. “We find insured paper so attractive that there’s no need to go to lower-quality bonds,” says Larry Troutman, manager of the Dreyfus California Tax-Exempt fund.

Of course, when so many investors are nervous, there is opportunity for those who can take more risk. If you can do the research, you can certainly find terrific yields on uninsured local bonds that nobody wants. With higher federal taxes on the way, demand for tax-exempt munis is not going away.

But if you are the typical muni investor, all you really want is a good yield and peace of mind. To make sure you have the latter, it is more important than ever to know the bond issuer’s financial health--and the prognosis.

Five Troubled Munis

These five California municipal bond issues are listed as the most worrisome of 41 troubled issues tracked by California Municipal Bond Advisor newsletter in Palm Springs. The newsletter says all five have insufficient funds to make their next debt payments, though they could be bailed out before actually defaulting.

* City of Ione, Special Tax Bonds Community Facilities District, issue 1989-2. Amount outstanding: $7.5 million. Issued in 1991.

* City of Ione, Special Tax Bonds Community Facilities District, issue 1989-1. Amount outstanding: $5.2 million. Issued in 1991.

* Oxnard Town Center Community Facilities District, issue 88-1. Amount outstanding: $14 million. Issued in 1988.

* Central San Joaquin Financing Authority Public Capital Improvement Revenue Bonds. Amount outstanding: $29.7 million. Issued in 1990.

* First San Diego River Improvement Project Special Assessment 1915 Act Bonds. Amount outstanding: $24 million. Issued in 1987.

Source: California Municipal Bond Advisor