California Muni Bonds Deserve More Credit
Looking for a bargain? You may not have to look much farther than your own backyard. Many investment pros say tax-free California municipal bonds represent some of the best values in today’s marketplace, yielding far more than U.S. Treasury bonds on an after-tax basis.
“They’re super-attractive,” said Duke Johnson, president of the La Jolla Institute for Wealth Management near San Diego. “We’ve been preaching that to our clients for quite some time.”
Yet, even investors in the 28% federal marginal tax bracket and up--who have historically benefited most from tax-free income--continue to overlook muni bonds and muni bond mutual funds.
Some investors, especially those who’ve grown accustomed recently to the stock market’s gaudy returns, regard munis as boring instruments best suited for “old ladies in tennis shoes,” noted Joseph Krist, assistant vice president in charge of credit analysis for Oppenheimer’s municipal bond funds. Others view them as risky plays in light of Orange County’s debacle four years ago.
Neither reflects the true opportunities that lie in California municipal bonds, managers argue.
For instance, if you think muni bonds are boring, consider the numbers. As recently as last week, many California muni bonds were yielding about 95% of what U.S. Treasuries of equivalent maturities were paying out, noted Zane Mann, publisher of the California Municipal Bond Advisor newsletter in Palm Springs. That is about 10 to 15 percentage points higher than the historic norm.
Remember, California muni bond investors don’t pay federal or state taxes on that income. So even though a California muni bond may yield, say, a ho-hum 4.75% versus 5% for an equivalent Treasury bond, that 4.75% yield is really worth more.
A lot more. Indeed, a California investor in the top 48.9% federal and state marginal tax bracket would have to find a fully taxable bond yielding around 9.3% to earn the same net amount.
“To earn those kinds of yields in the corporate market, you’d have to expose yourself to much more credit risk,” Krist argues.
And what about risk? Yes, muni investors do expose themselves to greater credit risk--that’s the possibility that the issuer will default on its payments--than with a Treasury bond backed by the full faith and credit of Uncle Sam.
But let’s put this into perspective, too: The California Municipal Bond Advisor estimates that by the end of this year, 15 California muni issues will have defaulted, representing about $160 million in principal.
This marks a slight reduction from 1997, when 16 issues representing $212 million defaulted.
Moreover, defaults this year represent less than half of 1% of bond issuance, Mann noted. “The safety of California bonds is still extraordinary,” he said.
For many investors, mutual funds are the easiest way to own tax-free munis. To find some good California bond funds, we scoured Morningstar Inc.’s database of 171 such funds.
First, we wanted only those yielding more than 4.37%, which is what the average California muni bond fund is paying out. But there’s more to a bond fund than its yield. So we tossed out all funds that couldn’t outdo two-thirds of their peers based on “total return” (that’s yield plus or minus any change in principal, or share price) year-to-date, over the past three years and over the past five years.
Why did we go out five years? Because we wanted to make sure that these funds did well even including 1994, when market interest rates surged.
This left us with 18 funds. Then, we threw out the remaining funds whose average credit quality wasn’t at least “A.” We did this for a reason. As David MacEwen, who oversees the American Century Funds’ muni portfolios, notes, the average difference in yields between the highest-quality “investment grade” muni bonds and non-investment grade bonds now is extremely narrow--around 35 basis points, or 0.35%. He argues that it isn’t worth owning lower-risk bonds with such marginally higher yields, given that high-quality bonds are so much easier to sell in emergencies.
Narrowing Down the Prospects
After we eliminated all funds that Morningstar considers riskier than average, we were left with 13. Some details on those funds:
* Investors interested in only the highest-quality bond funds may want to consider . . . Vanguard California Tax-Free Insured Long-Term (no load; minimum initial investment: $3,000; phone: [800] 662-7447). This fund seeks out issues whose repayment is guaranteed with private insurance, a safety-enhancer. As a result, 96% of its bond holdings are rated AAA, the highest quality.
Other funds in this category are Stagecoach California Tax-Free Bond A (4.5% load; minimum: $1,000; [800] 222-8222) and Schwab California Long-Term Tax-Free Bond (no load; minimum: $1,000; [800] 435-4000). Both funds invest more than 80% of their assets in bonds rated AA or better.
* Investors interested in the highest yields may want to consider . . . Franklin California Tax-Free Income (4.25% load; minimum: $1,000; [800] 342-5236), which invests in a broad mix of high- and lower-quality long-term bonds; and USAA California Bond (no load; minimum: $3,000; [800] 382-8722), whose manager, Robert Pariseau, is willing to go after the lower end of the investment-grade universe to boost yield.
Yield hunters should also consider three funds that typically own lower-rated, but still investment grade, munis. The funds: Prudential California Municipal Income A (3% load; minimum: $1,000; [800] 225-1852); American Century-Benham California Municipal High Yield (no load; minimum: $5,000; [800] 345-2021); and John Hancock California Tax-Free Income A (4.5% load; minimum: $1,000; [800] 225-5291).
* Investors focused on total returns may want to consider . . . Oppenheimer Main Street California Muni A (4.75% load; minimum: $1,000; [800] 525-7048); T. Rowe Price California Tax-Free Bond (no load; minimum: $2,500; [800] 638-5660); Seligman Municipal California High Yield A (4.75% load; minimum: $1,000; [800] 221-2783); Tax-Exempt Fund of California (4.75% load; minimum: $1,000; [800] 421-4120) and Franklin California Intermediate-Term Tax-Free (2.25% load; minimum: $1,000; [800] 342-5236).
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Muni Funds: Some Options
Investors hunting for mutual funds that own tax-free California muni bonds might start here. These funds pay above-average tax-free yields and all have generated above-average total returns (interest earnings plus capital appreciation) year-to-date and over the last five years.
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Current Year-to-date 5-yr. annual Fund yield total return* tot. return** Franklin CA Tax-Free Income 5.4% 6.8% 6.5% USAA CA Bond 5.2 7.1 7.0 Prudential CA Muni Income A 5.2 7.0 7.4 American Cent. CA Muni High Yield 5.0 6.8 7.2 Hancock CA Tax-Free Income A 5.0 6.8 6.7 Vanguard CA Tax-Free Insured L/T 4.9 6.1 6.9 Oppenheimer Main St. CA Muni A 4.9 6.5 6.9 T. Rowe Price CA Tax-Free Bond 4.8 6.6 6.5 Seligman Municipal CA High Yield A 4.7 6.4 6.6 Tax-Exempt Fund of CA 4.7 6.3 6.3 Schwab CA Long-Term Tax-Free 4.7 6.7 6.4 Franklin CA Inter.-Term Tax-Free 4.6 6.6 6.5 Stagecoach CA Tax-Free Bond A 4.5 7.1 6.5 Average California muni bond fund 4.4 5.6** 5.9
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* Figures are through Dec. 11.
** Figures are through Nov. 30.
Source: Morningstar
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California Municipal Bonds
T. Rowe Price Associates tracks the yields of 20 California municipal bonds and the Bond Buyer index of 40 national issues.
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Bond Buyer 40-bond index: 5.10%
California index: 4.96%
Five Widely Held California Bonds
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Yield Issue Coupon Maturity Dec. 4 Friday Calif. general-obligation 10-yr. (generic) 4.05% 4.05% Calif. general-obligation 20-yr. (generic) 4.90 4.90 San Joaquin toll road 5.375% 1/15/29 4.96 4.96 Calif. public works lease rev. 5.50 10/1/14 4.68 4.68 San Fran. airport (insured) 5.65 5/1/24 4.90 4.90
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Source: T. Rowe Price & Associates in Baltimore, which manages a $150-million California bond fund
Note: All yields are as of 2 p.m. Friday. Yields are based on institutional trading, retail prices and a survey of California brokers. Yields offered to individual investors will vary.
