Contrary to Popular Wisdom, Muni Bonds Can Yield Pain

California tax-free municipal bonds were, overall, a solid investment in 1997, as they usually are.

But that’s certainly not how the owners of a $23.3-million Palmdale Assessment District No. 88-1 bond issue feel. Their bonds went into default last year--helping to make 1997 a record for California muni defaults, despite the state’s stunningly healthy economy.

Figures compiled by the Palm Springs-based California Municipal Bond Advisor newsletter, which tracks the California muni market, show that a record $212.1 million in California muni issues fell into default last year, meaning they missed an interest or principal payment due bondholders.

That was up 140% from the $88.2-million worth of muni issues that defaulted in 1996 and four times the default sum in 1993, which may have been the low point for the state’s economy (or at least for Southern California).

What’s wrong with this picture? And how big a worry is the surge in defaults for the typical California muni bond owner?

To answer the second question first, while $212.1 million sounds like a lot of money, it is tiny slice of the huge California muni pie--estimated at about $130 billion, including all state and local bond issues. Which means your chances of owning a defaulted bond are pretty slim.

But for a particular type of muni bond--typically small, land-related or assessment-district issues classified as Mello-Roos or Marks-Roos bonds--the chances of getting stuck with a loser were significantly higher last year.

Of the 16 individual issues that defaulted last year, “only one wasn’t a land-related deal,” said Zane Mann, publisher of the California Municipal Bond Advisor.

Besides the Palmdale issue mentioned above, other bonds that defaulted last year included a $13.8-million, 1990-91 issue from the Antelope Valley/East Kern Water Agency; a $55-million, 1990 issue from the Lake Elsinore Public Finance Authority; and a $19-million 1988 issue from the Val Verde School District.

The sudden wave of defaults in such issues is a reminder that while the state’s coastal region is booming once again from north to south, the economic recovery--and recovery in real estate values--is slower in the interior, Mann said.

Problems usually arise, Mann said, with financially weak developers who years before convinced a local government agency to issue bonds to pay for property improvements, such as sewers, in advance of a housing development. But then that housing never was built, or enough of it wasn’t built, so the money to service the debt (from assessments) never arrived or was too little too late.

“Typically these involve the small real estate developer who goes to the city council, sells them a bill of goods, then walks,” Mann said.

Even if there is no money with which to pay interest owed on the bonds, defaults “usually get solved in one way or another,” Mann said. Foreclosure on the property frequently provides a way for bondholders to collect principal, but how much of their original investment is recoverable may depend on how much the value of the land has fallen since the bonds were issued.

If the real estate market in areas such as the high desert begins to rebound in 1998, Mann said, default rates may decline this year.

Still, “we aren’t quite sure this has all bottomed out,” he said. Indeed, his Watch List of muni issues that might run into trouble this year now contains 39 issues totaling $709 million.

While most California muni investors have little to worry about--and those that own privately insured issues have nothing at all to worry about, except the financial health of the insurer--Mann has basic advice for muni bond investors who like to buy individual issues, as opposed to bond mutual funds: If a broker calls trying to sell you a high-yielding, uninsured, nonrated muni from a town you’ve never heard of, don’t take the bait.

With high-quality, long-term California muni bonds now yielding around 5% tax-free, “a muni bond paying 8% [tells you] that something’s wrong with it,” Mann said--because you don’t get a higher yield without taking significantly higher risk.

Briefly: Some Wall Streeters, marveling at the rally in U.S. stocks on Monday, noted that history is replete with examples of tremendous market moves borne of financial crises like the one that has ravaged East Asia.

The great U.S. bull market surge of 1995, for example, began even as investors were still fretting over the Mexican peso devaluation of December 1994 and Orange County’s bankruptcy that same month. And the bull market of the 1980s began in 1982--in the midst of the Latin American debt crisis of that year.

It’s really not such a strange coincidence. If a major financial crisis encourages central banks, such as the Federal Reserve, to either leave interest rates alone or cut them, that is, naturally, a great tonic for Wall Street.

*

Tom Petruno can be reached at tom.petruno@latimes.com

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Troubled Munis

The dollar amount of California municipal bonds that went into default in 1997 was a record $212 million, up sharply from 1996. Still, that is a relatively tiny sum compared with the entire California muni universe. Value of defaulted bonds each year, in millions:

1997: $212.1 million

Source: California Municipal Bond Advisor