Iffy Bonds Now May Prove to Be Smart Bet
You didn’t buy that house you wanted in 1998. Now it’s twice the price.
You didn’t buy that depressed technology stock last October when it was $5. Now it’s $35 a share.
A year or two from now, will current yields on California municipal bonds look like the same kind of missed opportunity?
Amid the worst budget crisis in California’s history, many investors nationwide have an understandably dim view of the Golden State’s financial health, and that is reflected in the depressed prices, and relatively high yields, of the state’s IOUs.
The budget deal passed by the Legislature last week looks to many critics like a lot of smoke and mirrors. And it fails to fill in the entire deficit the state faces.
The Legislature is taking the Scarlett O’Hara approach: Let’s worry about that tomorrow.
That’s OK if you don’t rely on other people to help pay your bills. But California needs money to build schools, repair bridges and finance other big projects.
That requires the use of bonds: Investors put up cash today and the state agrees to pay it back in, say, 20 years. Each year until then the state pays the investors a fixed rate of interest -- tax free -- as compensation.
The critical question with bonds is, how much interest is enough to compensate for two main risks: the chance that the borrower might not repay, and the chance that inflation might rise over time, eroding the value of the securities’ fixed return.
Assessing those and other risks, the market’s verdict as of late last week was that the state should pay an annual interest rate of about 5.4% to borrow via bonds that mature in 20 years.
That is well above what is being paid on bonds of other states and municipalities nationwide that are considered to be higher in quality.
What makes the yield so intriguing is that it’s exempt from federal and state income tax for California residents. For someone in the combined federal/state tax bracket of about 34%, a 5.4% tax-free yield is the same as earning 8.18% on a fully taxable investment, such as a corporate bond or a bank CD.
The higher your tax bracket, the higher the effective yield on tax-exempt bonds.
Brent Kessel, a certified financial planner at Abacus Wealth Management Inc. in Pacific Palisades, believes that the state’s bonds are “absolutely the best deal in the bond market today,” and he has been trying to convince many of his income-oriented clients of that.
But he concedes that it can be a difficult conversation.
Some clients remember Orange County’s bankruptcy in 1994 and what that did, at least temporarily, to the value of the county’s bonds, Kessel said.
“This could blow up,” one client told Kessel, referring to the state’s fiscal situation. Why take the chance -- especially when there is no shortage of other muni bonds available from counties, cities and other California entities at yields that aren’t too far below what the state is paying?
But then, all investing is taking a chance. And often, when the risks appear to be highest is when the best opportunities abound -- like the stock market in early March, before the war in Iraq began and many shares were trading near five-year lows.
Many professional investors, however, don’t see much, if any, appeal in the state’s general obligation bonds at current yields.
“I don’t think there’s any value there,” said Steve Galiani, a muni bond fund manager at Wells Capital Management in San Francisco.
Like most bond pros, Galiani believes California ultimately will pay bond owners what it owes them, so it isn’t the risk of default that puts him off -- even though it’s not clear where the Legislature will find the money to plug a budget gap expected to total at least $8 billion by spring.
Instead, it’s a question of whether the yields are adequate to cover a number of other risks that could drive investors to demand higher rates on newly issued bonds, further depressing the prices of older bonds, Galiani said.
Those risks include:
* The heavy supply of California bond deals in the pipeline. The Legislature’s budget calls for the state to borrow $14.1 billion via bonds to plug much of a $38-billion shortfall.
On top of that sum, there are $24.1 billion in voter-approved general obligation bonds that are still to be issued over the next few years to finance major projects, especially education-related ones.
If investors begin to feel overwhelmed by the supply, the state will have to pay more to get buyers to take the bonds. In turn, existing bonds issued at lower fixed rates would be expected to fall in price to make their yields match what’s available on new bonds.
To Robert Gore, veteran muni bond trader at brokerage firm Crowell Weedon & Co. in Los Angeles, there’s simply no reason to rush to buy state debt. “You can certainly afford to wait,” he argues.
* The chance that California’s credit rating, already the lowest of any state, could be cut further.
Rating firm Standard & Poor’s lowered the state’s grade to BBB on July 24. That is two notches above the “junk,” or non-investment-grade, rating. If the rating were to drop again, investors might demand higher yields to compensate.
* The generally poor backdrop for all bonds, as interest rates rise across the board, reflecting investors’ growing belief that the economy is accelerating -- which could boost inflation over time.
If inflation stays around 2% a year, the real return of a 5.5% fixed bond yield would be 3.5%. If inflation were to rise to 4%, the real yield would drop to 1.5%.
Kessel acknowledges that all of the above are risks for buyers of California bonds.
But he notes that, for investors who expect to buy individual bonds and hold them to maturity, what happens to the bonds’ market prices in the interim is moot. They may fall in value, but if the owner doesn’t sell there’s no loss. And at maturity, the face value of the bond would be repaid.
In the meantime, the investor continues to collect interest at the bond’s stated rate.
“I know I’m going to get every dollar of principal and interest eventually,” Kessel said.
Some investors may worry that if the budget situation worsens the Legislature could do something crazy, like declare a moratorium on bond payments. But the state constitution requires revenue to go toward education spending first, then debt-service payments before other expenditures.
At a minimum, Kessel said, investors in high tax brackets ought to at least begin to investigate the opportunities in California muni bonds, even if they believe there may be a better time to buy in coming months.
There are three major ways to own muni securities:
* Individual bonds. Kessel said he focuses on state bonds maturing in one to nine years. Generally, the shorter the maturity, the lower the yield.
Investors need the help of a broker or other financial advisor to buy individual securities. Typically, the minimum investment is $5,000.
A good place to start is a Web site sponsored by the Bond Market Assn., www.investinginbonds.com.
* Open-end mutual funds. The funds offer the simplest way to own muni bonds. Investors get a piece of a diversified portfolio for as little as $1,000. Tax-free interest earned on the bonds is passed through to investors after management fees are deducted.
The major drawback to the funds: Because the portfolios are actively managed there is no set maturity date and their yields aren’t fixed. If bond values fall, fund investors will see that reflected in their share price.
A prolonged decline in bond values could mean investors would never recoup their original investment, though higher market interest rates also would mean that the funds’ interest payments would rise over time.
For more information, try www.morningstar.com, and scroll down to the “bond investing” link on the left.
* Closed-end funds. These are bond portfolios that trade on major exchanges, such as the New York Stock Exchange. Like open-end funds, they pass through to investors the interest earned on the underlying bonds. The funds also often use leverage -- borrowed money -- to increase their potential returns.
One quirk of closed-end funds: Their stocks often trade at discounts to the true value of the portfolio. That can be an opportunity, because an investor may end up paying, say, 90 cents for $1 worth of bonds.
One big sponsor of California muni closed-end funds is Nuveen Investments. For more information, go to www.nuveen.com.
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California muni funds: a sampling
Here are some of fund-tracker Morningstar Inc.’s highest-rated California muni bond mutual funds, and their total returns (interest earnings plus or minus principal change) over three periods. Investors should check with the fund companies to get the current annualized yields on the funds.
*--* Annualized Annualized YTD return 3-year 5-year SEC through Fri return return yield Franklin CA High Yield 0.7% 6.1% 4.0% 4.8% American Century CA High 0.4% 6.7% 5.2% 4.5% Yld Schwab CA LongDTerm 0.1% 6.6% 5.0% 4.6% Tax-Free Fidelity Spartan CA -0.2% 6.1% 5.2% 3.4% Municipal Vanguard CA Long-Term -0.7% 6.2% 5.5% 3.3% Tax-Exem T. Rowe Price CA Tax-Free -0.5% 5.9% 4.8% 3.3% Nuveen CA Municipal R -0.7% 4.2% 3.7% 4.3% Evergreen CA Municipal 1.1% 6.2% 5.3% 2.0% HighMark CA Interm Tax-Fr -0.4% 5.4% 4.9% 2.1% PIMCO CA Intermediate Muni -1.4% 5.0% NA% 2.7%
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Note: Yields shown are latest in Morningstar’s database but may not be current.
Source: Morningstar Inc.
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Tom Petruno can be reached at tom.petruno@latimes.com.
