Why Big-Risk Takers Now Like Low-Risk Munis

The general rule on Wall Street is that whenever investors want more of something, the Street is happy to oblige--usually with securities that would have been better left uncreated.

It worked that way earlier this year with absurdly high-risk initial public stock offerings, for example, and with Internet-only stock mutual funds.

But the Street hasn’t been able to do much for the horde of California investors who’ve been lining up to buy tax-free municipal bonds this year: While demand is way up, the supply of new bonds has waned.

In the often upside-down world of finance, that is actually good news. It is making for some very appealing returns in the muni market. And the opportunities still look quite attractive for investors hungry for high yields and eager to add an element of capital preservation to their portfolios.

Do bonds bore you? Or you just don’t understand them? Then you’re in the majority, not the minority. It’s OK to feel sheepish about bonds. But with the yields available on California munis today, your eyes should quickly unglaze: Depending on your tax bracket, you would have to earn 7%, 8% or more in annualized yields on corporate bonds or bank CDs to equal what munis are paying.

If those numbers still don’t sound like much in a world where individual technology stocks can easily rise 20% or more in a day, you may be interested to know that one of the key sources of demand for California munis this year has been the Silicon Valley and Tech Coast crowd.

“There is a lot of demand from the IPO millionaires, the Internet millionaires,” says Stephen Galiani, managing director of the muni bond group at Wells Capital Management in San Francisco.

“As people become wealthier they become more conservative with their money,” Galiani says. Many muni bond buyers today have already enjoyed much in the way of capital appreciation; now they’re looking for capital preservation--which is what bonds are all about.

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First, a bit of background on the muni bond market to explain where we are today: Munis are IOUs issued by states, municipalities and local government agencies. They typically fund long-term building projects (sewers, roads, schools, etc.) or are used to manage cash flows (shorter-term muni IOUs, for example, may be used to fund a government entity’s operations until tax payments are received).

Despite some high-profile problems over the last few decades--such as Orange County’s bankruptcy in the mid-1990s--the simple fact is that muni bonds have been extremely safe investments. Defaults happen, but they are quite rare.

Like Treasury or corporate bonds, most muni bonds pay a fixed rate of interest to the bond holders for the life of the security. At maturity, you then get back the face value of the bond (say, $1,000).

What’s different about munis is that the interest they pay is usually exempt from federal income tax and also from state income tax in the state where the securities are issued.

The double tax exemption allows muni issuers to pay lower rates of interest to borrow, because the true yields--the “taxable equivalent” yields--are much higher for the buyers of the bonds, courtesy of the tax exemption.

The accompanying chart illustrates what annualized muni bond yields of 4%, 5% and 6% are really worth, depending on your tax rate.

For a married California couple whose taxable income this year will be in the approximate range of $105,000 to $159,000, their federal marginal tax bracket is 31% and their state marginal tax bracket is 9.3%. Because state taxes are deductible on federal returns, their combined tax rate is a bit lower than they might suspect, at about 37.4%.

But that still means every dollar of taxable interest earned is reduced to 62.6 cents after taxes.

If you earn $1 of tax-exempt interest, by contrast, you keep the full $1. You get the picture.

When you work the math you find that, in the 37.4% tax bracket, you’d have to earn at least 8% on a fully taxable bond or CD to net the same amount of interest that a 5% tax-free muni bond gives you.

That’s why many California investors have turned to munis this year. Muni yields, particularly on long-term bonds (maturing in 10 or more years), are extremely attractive relative to most alternatives, including U.S. Treasuries, which are federally taxable but not state taxable.

As of Friday, Galiani said an investor looking for the highest-quality muni issues in California could snare yields of 4.30% on five-year bonds, 4.65% on 10-year bonds and 5.10% on 15-year bonds.

Again, check your tax bracket in the chart, and you’ll get an idea of what those yields are worth if you’re comparing to other investments.

Yields might be even higher were it not for the thin supply: California issuers, including the state and all local entities, have sold $11.5 billion in new bonds this year. That’s down 23% from the first-half of 1999.

Flush with cash from the strong economy, local governments’ borrowing needs are down, notes Zane Mann, editor of the California Municipal Bond Advisor newsletter in Palm Springs. Issuance should pick up somewhat in the fall, but perhaps not enough to satisfy demand.

The upshot of robust demand is that it’s boosting the market value of existing bonds. That’s why, if you look at the year-to-date “total returns” listed for California muni bond mutual funds in The Times’ fund listings today, you’ll see many funds are up 6% or more already this year. That factors in the interest they’ve already paid for the half year, plus the rise in the market value of the bonds in the portfolios.

Which brings up the question of how best to own munis. The old rule of thumb: If you’re going to buy individual bonds, you should have $100,000 minimum to invest in order to build a diversified portfolio.

Otherwise, Mann says, “You’re better off in mutual funds.” There are scores of California bond funds available. Some of the biggest fund operators include Vanguard Group, Alliance Capital, Franklin-Templeton Funds and American Century Investments. You can find them all on the Internet.

If it’s individual bonds you want, you’ll need a broker’s help. To prep yourself, there’s a good interview with veteran California muni fund manager David MacEwen on the Web. It was done in 1999, so you can ignore his market outlook stuff. He makes good points about risk, how bonds can be “called,” and more.

Go to https://www.forum.schwab.com/SN099LowerArchiveMacEwen51.html.

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What Muni Yields Are Really Worth

Here’s a look at what California municipal bond tax-free yields of 4%, 5% and 6% are truly worth to investors, by tax bracket. Example: If your combined (federal and state) effective tax rate is 37.4%, a 5% tax-free yield is the equivalent of earning an 8% fully taxable yield, such as on a corporate bond or a bank CD. The “effective” tax rates shown account for the deductibility of state taxes on federal returns.

Sources: California Municipal Bond Advisor, Times research

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Tom Petruno can be reached by e-mail at tom.petruno@latimes.com