Calif. Munis Drawing Buyers Despite Worries
California is facing a huge budget deficit, but concerns about the state’s fiscal health don’t appear to be having much effect on its municipal bonds.
In fact, California muni bond mutual funds have performed slightly better in recent months than the average muni bond fund nationwide.
Reduced stock market expectations and meager returns on short-term accounts such as money market funds may be attracting more California investors to tax-free muni bonds, analysts said.
“People are looking for something else,” said Don Cassidy, senior research analyst at fund data tracker Lipper Inc. in Denver.
Declining yields on many types of bonds since March have boosted the market value of older, higher-yielding issues.
The annualized yield on a Moody’s Investors Service index of 20-year muni bonds from issuers nationwide stood at 5.28% last week, down from 5.46% in late March.
Interest paid on bonds issued by California, its agencies and municipalities generally is free of state and federal income tax for residents. That has long made munis highly appealing to many income-oriented California investors, especially those in higher tax brackets.
For a married couple in the 36.5% combined federal and state marginal tax bracket (that bracket begins at taxable income of about $112,000), a California muni yield of 5% is equivalent to a fully taxable yield of 7.9%, according to the California Municipal Bond Advisor newsletter in Palm Springs.
Even though bond yields have come down, “the municipal market is still attractive compared to taxable investments,” said Mary Miller, assistant director of fixed-income investments at mutual fund firm T. Rowe Price in Baltimore.
A 10-year U.S. Treasury note, for example, now yields about 5%, which is less than the yield on many 10-year muni issues. Treasury interest is subject to federal income tax, though not state tax.
Investors in the average California muni bond mutual fund have earned a “total return” (interest plus net change in principal value) of about 2.5% since March 31, according to Lipper, compared with 2.3% for muni funds nationwide.
In the last 12 months, the average total return on California muni funds has been 5.7%, compared with 5.5% for the nationwide muni average. The true returns are higher, depending on an investor’s tax bracket.
The average stock mutual fund, by contrast, has fallen 11.6% in the last year, according to Lipper.
Many higher-income California investors prefer to buy individual muni bonds rather than mutual funds. That entails the risk that the bond issuer could face financial trouble and be unable to make interest payments. But California muni issues have historically been a fairly safe investment.
Although the dollar value of California bonds that defaulted rose to $161 million in 2001 from $113 million the year before, much of that stemmed from 10 troubled bond issues, totaling $118 million, sold by now-defunct San Francisco underwriter Pacific Genesis Group, according to the California Municipal Bond Advisor, which tracks such data.
Most bonds that get into trouble are issues of small municipalities. Financial advisors typically warn investors to stick with bonds of the state itself or of large municipalities or agencies.
Even though most bond issuers make good on their interest payments, bond investors can lose money, at least on paper, in other ways: The market value of their bonds can decline if investors become more fearful about certain issuers--even if default is highly unlikely--or if market interest rates rise, depressing the value of older, lower-yielding bonds.
Some analysts warn that credit-quality concerns are on the horizon for California muni bonds. The state’s projected budget shortfall of $23.6 billion could mean a ratings downgrade for California general obligation bonds this year. It also could mean a deterioration of the credit quality of state agencies, experts said.
For now, however, “there is concern about downgrades, but prices [of California issues] remain strong,” said Dan Solender, who manages nearly $4.5 billion of California bonds in two funds for Vanguard Group in Malvern, Pa.
A rising supply of new muni issues also could depress the value of older bonds and drive up yields, if investors’ interest wanes.
New California muni issuance has totaled $14.8 billion this year, compared with $11.7 billion in the same period last year, according to data tracker Thomson Financial.
What’s more, some large muni issues are looming, including $4.5 billion of bonds related to the state’s liability settlement with the tobacco industry and the $11-billion power bond issue to cover shortfalls incurred during last year’s energy crisis.
Dave MacEwen, head of fixed-income investments at American Century Funds in Mountain View, Calif., said investors considering a move into munis might want to save some cash to buy the power bonds, which are expected to offer attractive tax-free yields.
But MacEwen warned that investors who are frustrated with low returns on bank certificates of deposit and other short-term accounts shouldn’t rush into muni bonds or bond funds without understanding the risks.
He cautions that investors who worry about losing money in bonds if market interest rates rise should stick with funds that own bonds maturing in the next few years, so-called intermediate-term funds. Yields are somewhat lower on those funds than on longer-term funds, but the principal value of intermediate-term bonds would suffer less than longer-term bond values if market rates indeed rise.
Investors who are nervous about credit quality also can focus solely on insured muni issues or on funds that buy only insured bonds.
