Muni Bondholders Stand Firm in Shake of Quake

The mammoth California municipal bond market, which has weathered disaster after disaster (natural and man-made) for four years, is so far shrugging off the Southland quake.

Bond traders reported little activity in the California muni market Tuesday, the first post-quake trading day because Monday was a holiday. Despite fears that damage costs, broken freeways and broken lives will sink the Southland further into recession--worsening the already weak financial condition of state and local government--muni owners aren’t in a mood to sell.

Why not? Most investors probably can think of two logical reasons not to part with their California tax-free muni bonds or bond mutual funds:

* Belying the worst recession since the 1930s, there have been few defaults in recent years among the hundreds of California government entities that have issued bonds for public works and other projects. Simply put, bond issuers have honored their debts, and most people who have sold munis since 1989 betting otherwise have erred. Thus, one more disaster “is like old hat to this market by now,” says Bill Loring, manager of the Colonial California Tax-Free bond fund.

Last year, only four California muni issues worth a total of $56 million actually stopped making interest payments to bondholders, according to Zane Mann, publisher of the California Municipal Bond Advisor newsletter in Palm Springs. In a total California muni market worth an estimated $130 billion, those defaults were barely a blip.

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What’s more, bond-rating services say that so far, they’ve identified few Southland muni issues that are at risk because the buildings (such as courthouses) or other projects that were financed by the bonds were harmed by the Northridge quake. “Damage in most instances is not substantial, as far as we can tell,” says Amy Doppelt, analyst at rating agency Fitch Investors Service in New York.

* With the rise in federal tax rates last year, tax-free muni bonds make more economic sense than ever for many investors. The Vanguard California Tax-Free Insured bond fund, for example, currently yields about 4.7%, annualized. For a California couple in the combined federal-state marginal tax bracket of at least 34.7% (taxable income of $61,241 or more), that 4.7% is equivalent to a taxable yield of at least 7.2%. It isn’t easy to find 7%-plus yields anymore.

Something else may be encouraging California bond investors to sit tight, as well: the idea that bad news can actually be good news. After all, in the wake of south Florida’s killer hurricane in 1992, the rebuilding boom there pumped hundreds of millions of dollars into the local economy.

Similarly, if quake victims buy new goods to replace what was destroyed, they’ll boost sales tax revenue; if they rebuild, they’ll create construction jobs and thus new income tax revenue. Either way, state and local coffers may take in more money, short-term, than expected. Anything that strengthens the finances of bond issuers gives investors more confidence to hold the bonds.

Still, investors’ currently sanguine view of the California muni market may not last. For one thing, Gov. Pete Wilson’s proposed state budget for the next fiscal year, beginning July 1, is balanced now only because he’s counting on massive (and doubtful ) federal aid to pay for illegal immigrants.

As we get further into budget-wrangling season and the state’s share of emergency costs for the Southland quake mushrooms, bond owners may begin to fear again for the financial health of the state and of cities, counties and other entities that will eventually feel the state’s fiscal pain--perhaps with deeper budget cuts than last year’s.

And if that happens against the backdrop of rising market interest rates this spring because of the strong U.S. economy, the state’s muni bonds could suffer a double whammy: They would drop in price first because of credit-quality concerns and second because higher market interest rates automatically clip the value of all older bonds.

It’s important to remember that the muni market now is very dependent on individuals, through their direct holdings and via mutual funds. Other muni owners, such as banks, have faded as players. Thus, if individuals begin to sell, or simply stop buying, the market could hit a temporary vacuum.

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What’s a muni owner or potential buyer to do? First, just realize that the market may be a little too blase about the state’s budget outlook. Some experts say investor optimism has pulled yields on the state’s popular general obligation bonds down to levels that may be too low, relative to other bonds. With 25-year G.O. bonds paying about 5.4%, “These yields don’t build in the ongoing credit worries about the state,” argues one veteran Los Angeles muni trader. If you’re hungry to buy, waiting a few months may pay off.

Second, you shouldn’t own muni bonds or any bonds today unless you can answer some basic questions: Do you have a good feel for the issuer’s financial health, if an individual bond? And no matter how attractive the yield you’re earning, can you accept the idea of a loss of some principal (if only on paper) should the market temporarily turn against California bonds on credit concerns or because of a rise in market interest rates?

Munis: The Big Picture

California, the biggest issuer of tax-free municipal bonds, is like other states now dependent on individual investors to buy and hold that debt--unlike 10 years ago, when banks and insurance firms dominated the market. How muni ownership has changed since 1983:

Pct. of all munis owned:

Households 31.5% 39.4% Mutual funds 6.0 25.0 Insurance cos. 19.1 12.2 Bank trusts 6.5 8.4 Banks/S&Ls; 32.7 8.2 Closed-end funds 0 3.8 Other 4.2 3.0

Based on total dollar amount of bonds outstanding.

Source: The Bond Buyer