Mining for Munis

By RUSS WILES

Aug. 25, 1998 12 AM PT

Russ Wiles a Phoenix-based mutual fund columnist for The Times

Tax-free municipal bonds have long been a favorite investment for Californians seeking decent yields and portfolio diversification. With the stock market on the rocks, California muni bonds--whose interest is exempt from both state and federal taxation--may make more sense than ever for investors looking for alternatives.

Robert Pariseau, a former Navy aviator, has been in the cockpit of the USAA California Bond Fund since May 1995, and he has piloted the fund to one of the best records of any muni fund in recent years.

The Maryland native, now 48, spent eight years in the Navy. Later, he worked briefly for McDonnell Douglas while earning an MBA at Lindenwood College in St. Louis.

He joined USAA in 1984 and has worked as both a stock and bond analyst. Now, in addition to managing the California fund for USAA, Pariseau runs state muni bond funds for residents of Florida, Texas and Virginia.

He lives in San Antonio, where USAA Investment Management Co. is headquartered. The firm, founded in 1970, is an affiliate of the United Services Automobile Assn., a diversified financial company that caters largely to military personnel and veterans. However, no military experience is needed to invest in the group’s mutual funds.

Pariseau spoke recently with Russ Wiles, a Phoenix-based mutual fund columnist for The Times.

Times: California’s economy is on a roll, and that obviously provides a healthy backdrop for investing in bonds issued by the state or its municipalities. Do you think the good times will continue?

Pariseau: I think the economy will continue to do well. Probably the only cloud in the sky is the turmoil from Asia. Trade is very important to California, and we really haven’t seen any negative impact yet. But if it does occur, I think California will be able to handle it. It’s such a diverse economy and much more so than prior to the 1991 recession, with less emphasis on aerospace.

Times: What’s your basic strategy with the California Bond Fund?

Pariseau: We remain fully invested. We don’t try to time the market. We focus primarily on yield--fully tax-exempt yield that’s not subject to the alternative minimum tax [a special tax on certain types of income]. By concentrating on tax-exempt income, we’ll maximize our after-tax total return. We’re not trying to generate a lot of taxable capital gains. Income is the greatest percentage of return for any fixed-income fund, so why not focus on that?

One thing I’d like to mention is that munis are the only investment that’s quoted in a “hybrid” number. Unless you know how it’s compiled, you might think muni bond returns are inferior.

For example, our fund has been around since Aug. 1, 1989. From that date through March 31, 1998, you would have earned a 7.86% average annual return. That sounds terrible, but 6.26 percentage points of that 7.86% is after taxes, with the other part, 1.6 points, price appreciation.

In the 28% federal tax bracket [plus the state tax bite], that 6.26% in income works out to almost 9.5% [equivalent] yield on a taxable bond. If you add the price appreciation, the fund’s total return is better than 11%, which is nearly equal to the long-term rate of return on the stock market.

The point is that muni bonds typically give you a high, competitive yield for moderate risk. And by adding munis to your [stock holdings], you will decrease the overall risk of your portfolio. It’s a complicated, math-oriented process that investors have to go through to properly analyze munis, and it’s tough. But it shows that munis have been one of the best-performing asset classes over the past 20 years.

Times: How does your bond-picking strategy jibe with your outlook for interest rates?

Pariseau: My funds tend to hold longer-term bonds than many rival funds, which makes them a little more volatile. But that means our shareholders also will generate a higher after-tax return over time. As far as my outlook for interest rates, I’m a cautious bull but definitely a bull. With inflation so low, I’m willing to buy bonds with longer maturities.

Times: What are some themes you’re looking at today in picking individual bonds?

Pariseau: One is a focus on health care. This has been one of our highest industry concentrations over the last three or four years. When President Clinton’s proposal to deregulate health care was being considered by Congress, health-care bonds started trading cheaper, with some very decent yields forming. We decided to target bonds issued by very profitable hospitals with dominant market shares and talented managements. This is an essential industry. You need a hospital in your city. So we gravitated toward some of the more isolated rural hospitals that a lot of other investors were staying away from.

Some of our larger positions are in health-care facilities guaranteed by Cal-Mortgage, the California health facilities construction loan insurance program. The program includes bonds backed by essential yet smaller health-care facilities, typically in rural settings. Many are so small that they normally wouldn’t have access to the capital markets. The premiums that these health-care facilities pay to Cal-Mortgage go into an insurance pool. If anybody gets into trouble, the payments to bond investors would come from this pool.

If things really turned bad, then California would issue general-obligation debentures to back the bonds. So it’s a wonderful program. The bonds tend to trade fairly cheaply [meaning, providing above-average yields] compared to other health-care securities, yet they’re essentially backed by the full faith and credit of the state of California. And we still research the underlying facilities.

Times: How about some general California bonds you hold?

Pariseau: One favorite is the Pleasanton Joint Powers Financing Authority, which is yielding 6.15% and maturing in 2012. This is an assessment bond, which means that in return for getting city services such as streets, sewers, sidewalks, lights, water and more, property owners agree to pay an assessment along with their property taxes.

At the time we invested in 1993, the area was 64% developed. Pleasanton is about 25 miles southeast of Oakland. It has good highway access and a new [Bay Area Rapid Transit] station. It was being developed because there just isn’t much affordable business property in the Bay Area. Now the district is 84% developed. Pleasanton has attracted business from San Francisco and Silicon Valley, such as back-office operations. Several large companies such as Prudential relocated some of their people there at reasonable prices. The Pleasanton bond, when we bought it, was rated BBB. Now I think it’s ripe for a credit upgrade. It has the potential for an A rating.

Times: Any examples in Southern California?

Pariseau: The San Joaquin toll road is another large position. We bought these bonds in late 1994 and early 1995, at the bottom of the bond market. This road serves people wanting to bypass the infamous “Y” down in El Toro. It connects with the San Diego Freeway in Irvine.

San Joaquin traffic started slowly at first but has picked up since. I’ve been on that freeway. A couple of years ago, I was headed for a squadron reunion in San Diego, and I got stuck at the “Y” for two hours. It took me more than four hours on a Saturday morning to get from Long Beach to San Diego. So I felt pretty confident that these San Joaquin toll road bonds were going to work.

Times: Do you own many bonds in the L.A. area?

Pariseau: I don’t own a lot of bonds in the L.A. Basin. I like to own bonds in the Central Valley and the San Diego area. Nor do I own many bonds in downtown San Francisco. This reflects earthquake risk, which to me is a credit-analysis factor.

This isn’t to say that none of our bonds is exposed to earthquakes and faults--that would be pretty tough to pull off in California. But it does mean that our analysts consider earthquakes as a major risk factor. We ask what would happen to a facility and its revenue if an earthquake struck. We often buy insured bonds, as well as bonds issued by facilities that might be exposed to earthquake risk but which are guaranteed by Cal-Mortgage.

Times: Some investors prefer to own individual muni bonds rather than a fund. What are the pros and cons?

Pariseau: One advantage of owning individual bonds is if you’re investing to a target date, you can exactly match your investment horizon to the maturity of the bond. But you really need a portfolio of $1 million to $2 million, and you need to do your own credit research or have someone do it for you. I think somebody should own $100,000 holdings in at least 10 separate bonds. Otherwise, the trading costs will be so high that it would be cheaper to pay the 41-basis-point [0.41%] expense ratio that we charge on our fund.

Even if you save some money [in management fees] by creating your own portfolio, one blowup can cause a lot of damage, especially if you’re not properly diversified. . . .

In fact, you really should have professionals working for you who know what a bond is worth. The municipal market is very inefficient, which makes it hard for individuals to do credit research.

Another reason for owning a mutual fund is liquidity. With a fund, you can get your money back very quickly. You don’t have to call around for bids on bonds if you’re selling or offers if you’re buying. Finally, you have the advantage of automatic dividend reinvestment. This is an important component that affects your total return. If you can’t reinvest easily, then you won’t earn the yield you thought you were getting when you bought the bond.

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USA California Bond Fund

Strategy: Seeks high after-tax yield for California residents by investing in tax-free bonds issued by California cities, counties and other municipal entities.

Vital Statistic

Fund, 12-month: +9.88%*

Avg. long-term single-state muni fund, 12 months: +8.26%

Fund, 3-year annualized: +9.04%

Avg. long-term single-state muni fund, 3 years: +7.29%

Fund, 5-year annualized: +6.55%

Avg. long-term single-state muni fund, 5 years: +5.68%

Five biggest holdings as of July 28 (institutional prices as of same date also shown):

1. California Health Facilities Financing Kaiser Permanente 6.5% bonds due 2020 (price: $106.36)

2. Central Valley Financial Cogeneration Carson 6.2% bonds due 2020 (price: $105.66)

3. Vallejo Sanitation/ Flood Control District 5% bonds due 2019 (price: $99.74)

4. San Joaquin Hills Transportation Corridor zero coupon bonds due 2032 (price: $17.45)