ORANGE COUNTY IN BANKRUPTCY : Q & A : Light at End of Tunnel for Some Bondholders

Things may not be as bleak as they seem for holders of some bonds and bond mutual funds that may be affected by Orange County’s bankruptcy filing.

Chapter 9 proceedings, unlike other types of bankruptcy, specifically protect the income promised to holders of certain types of bonds, bankruptcy experts note. Meanwhile, managers of California tax-free funds maintain that investor yields are unlikely to be significantly affected by Orange County’s woes, even if the county eventually defaults on some of its debts. Asset values may take a small hit, but most big funds say the long-term impact will be modest.

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Q: How does a Chapter 9 filing protect bondholders, and which bondholders does it protect?

A: This section of the federal bankruptcy code specifies that income pledged to pay interest and principal on revenue bonds--those issued by utilities, transportation authorities and special purpose districts--must be paid directly to bondholders. The county may not use these dedicated funds to pay other bills, said Bennett Murphy, bankruptcy partner at the Los Angeles law firm Latham & Watkins.

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Q: What about holders of general obligation bonds? Are they protected too?

A: No. They become general unsecured creditors, which means they get paid after county employees, some suppliers, bankruptcy attorneys and federal debts are paid, Murphy says. The good news on this front is that Orange County is likely to need to borrow in the future. If it defaults on its bonds now, its borrowing ability will be severely hampered in the future. There may be some delay in paying interest on some issues, but experts maintain that defaulting would be a last resort.

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Q: What about California tax-free bond funds? How badly are they going to be hit?

A: Preliminary estimates are that the vast majority of funds have minimal exposure, generally between 1% and 2%, and that most of that is insured or backed in some way.

Using data from April, no fund has more than 12% of its assets in bonds potentially affected by the bankruptcy, said Donald Phillips, publisher of Morningstar Mutual Funds in Chicago.

In April, the most exposed funds were STI Classic Investment Grade, Merrill Lynch California Limited Maturity, Alliance Municipal Income and Franklin California Tax-Free, according to Morningstar. Portfolios have changed, however. In fact, Merrill Lynch says that currently there is no direct exposure to Orange County in its Limited Maturity fund. Other funds also may have reduced or added exposure since then, Phillips says.

Currently, all Merrill Lynch funds combined own a total of $71 million in Orange County bonds. All the bonds are “credit enhanced,” with either private insurance or escrow funds available if they are not paid, adds Kathy Keary, a Merrill spokeswoman.

Franklin says it does have a significant number of Orange County bonds, but the vast majority of its bonds are also backed by insurance or letters of credit. Only $25.6 million of the affected bonds are uninsured, a Franklin spokeswoman said. Those uninsured bonds are divided among three portfolios--the California Tax Free Income fund, the California Tax-Exempt Money fund and the Franklin Tax-Exempt Money Fund--and the uninsured exposure amounts to significantly less than 1% of each fund’s assets, the company says.

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Q: When you say a bond is “credit enhanced,” does that mean that there is no chance that it will go into default?

A: No. What it means is that a second entity--either a bank, insurer or escrow firm--is holding or has pledged funds to pay principal and interest on the debt. If the bond goes into default the bank, insurer or escrow company will be obligated to pay bondholders.

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Q: What about the other big mutual funds? What’s their exposure like?

A: T. Rowe Price says it has absolutely no Orange County paper in its money market funds. The company’s California Tax-Free Bond Fund has 0.6% of its assets in revenue bonds issued by a county department.

Fidelity Investments’ California Tax-free fund has 0.7% of its assets in Orange County bonds. More than half of that amount is in insured issues.

Scudder, Stevens & Clark says all of its Orange County bonds are privately insured, however, it has some Costa Mesa bonds--and Costa Mesa had $7 million invested in Orange County’s investment pool. But Costa Mesa has assured Scudder that the city is in good shape and will have no trouble paying on its bonds because of the Orange County debacle, says Jeremy L. Ragus, portfolio manager.

Dreyfus Corp. says its Dreyfus/Laurel tax-exempt money market fund holds precisely one Orange County general obligation note, and it accounts for less than 1% of the fund’s assets.

Vanguard says its high-yield fund has 1% of its assets invested in the bonds of an Orange County transportation agency. Otherwise, Vanguard’s exposure to Orange County’s credit woes are negligible, says Paul Flynn, portfolio analyst.

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Q: Are any multiple-state muni funds affected?

A: Literally hundreds of funds are affected, Morningstar’s Philips said, but the degree to which they are affected is negligible.

“This is one of those times that you really see a benefit to investing through mutual funds rather than buying bonds on your own,” Phillips said. “Fund managers diversify away a lot of the credit risk. While you certainly wouldn’t welcome a default in any event, it’s not as big a deal for fund investors.”

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Q: Will yields and net asset values drop on the funds that are affected?

A: Thanks to bond insurance and other credit enhancements, not by much. Net asset values of municipal bond funds declined across the board on Wednesday, largely due to fears that risky derivative securities could also bedevil other city, county and state investment portfolios. Many industry experts expect the market to bounce back, however.

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Q: I’ve been taking a beating all year on my bond funds and this is making me worried that the principal values in muni funds are not that secure. Is it time to bail out?

A: No. Individual events can spook the markets and play havoc with daily trading prices. But investors shouldn’t be concerned about day-to-day events. Instead, periodically examine your portfolio and ask: Am I properly diversified? Are my investments well suited to my goals? Are the investments in my portfolio performing as expected, given current economic and market conditions? If the answers are yes, sit tight. You’d be foolish to change a viable strategy because of a single event.

Q: When you say a bond is “credit enhanced,” does that mean that there is no chance that it will go into default?

A: No. What it means is that a second entity--either a bank, insurer or escrow firm--is holding or has pledged funds to pay principal and interest on the debt. If the bond goes into default the bank, insurer or escrow company will be obligated to pay bondholders.

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How Some Funds Are Exposed

Rating agencies and investors say that the vast majority of California tax-free mutual funds and money market funds have very little exposure to Orange County bonds, generally between 1% and 2%, and most of that is insured or backed in some way. Here are what some funds report.

Fund Company / Percentage of Portfolio in O.C. Bonds:

Fidelity California Tax-Free Fund: 0.7%

Franklin tax-free funds: less than 1% uninsured*

Dreyfus/Laurel Tax-Exempt Money Market Fund: less than 1%

Merrill Lynch California Limited Maturity: none

Other Merrill Lynch tax-free funds: less than 1%

Scudder California tax-free funds: none uninsured*

T. Rowe Price money funds: none

T. Rowe Price mutual funds: 0.6%

Vanguard High-Yield Tax-Free Fund: 1%

* No information on the percentage of fund holding insured Orange County bonds.