Gold out there

Bat­tered mu­nic­i­pal bonds give intrepid in­vestors en­tic­ing re­turns

The Washington Post Sunday - - BUSINESS - BY KATHY M. KRISTOF

Cal­i­for­nia’s bat­tered mu­nic­i­pal bonds could be pay dirt for in­vestors with a “cast-iron stom­ach.”

In an era of mea­ger yields, a 7 per­cent-plus re­turn on a seem­ingly safe mu­nic­i­pal bond might ap­pear ir­re­sistible. But if you’re an in­vestor in Cal­i­for­nia tax-free bonds, you know first­hand just how re­sistible that deal can be.

Re­act­ing to con­cerns about ris­ing in­fla­tion and Cal­i­for­nia’s bal­loon­ing bud­get deficit, in­vestors have been walk­ing away from Cal­i­for­nia mu­nis in droves. “ To buy Cal­i­for­nia bonds right now, you re­ally need a cast-iron stom­ach,” says Mar­i­lyn Co­hen, pres­i­dent of En­vi­sion Cap­i­tal Man­age­ment, a firm that spe­cial­izes in fixed-in­come in­vest­ments.

Yet ev­ery dis­as­ter brings op­por­tu­nity. Thanks to a sell-off in Cal­i­for­nia bonds in the fall, some is­sues boast ter­rific yields (bond prices move in the op­po­site di­rec­tion of yields). In early De­cem­ber, 15-year Cal­i­for­nia gen­eral-obli­ga­tion bonds — those backed by the state’s gen­eral tax­ing author­ity — yielded 5 per­cent to ma­tu­rity. Be­cause in­ter­est on muni bonds is ex­empt from fed­eral in­come taxes, that was equiv­a­lent to a tax­able yield of 7.7 per­cent for non-Cal­i­for­nia res­i­dents in 2010’s top fed­eral tax bracket of 35 per­cent. For Cal­i­for­ni­ans, who don’t pay state in­come taxes on in­ter­est from bonds is­sued by Cal­i­for­nia en­ti­ties, the tax­able-equiv­a­lent yield was as high as 8.5 per­cent.

But be­fore you think about in­vest­ing in Cal­i­for­nia bonds, you need to un­der­stand the sever­ity of the state’s woes. Cal­i­for­nia faces a $25.4 bil­lion bud­get short­fall over the next 18 months. The deficit is roughly twice what leg­is­la­tors had pre­dicted as re­cently as Novem­ber.

If Cal­i­for­nia were a cor­po­ra­tion, its in­sa­tiable ap­petite for debt would be prompt­ing con­cerns about de­fault. But as a govern­ment able to levy taxes when its cof­fers run dry, it’s un­likely that Cal­i­for­nia will re­nege on its gen­eral-obli­ga­tion bonds.

“Bar­ring ther­monu­clear war, Cal­i­for­nia will not de­fault,” says Scott Cot­tier, a port­fo­lio man­ager with the Op­pen­heimer funds.

The muni-bond mar­ket is hetero­ge­neous, and the health of state and lo­cal en­ti­ties varies enor­mously. More­over, about twothirds of the muni mar­ket na­tion­ally con­sists of rev­enue bonds, which are backed solely by the rev­enue gen­er­ated by a bond-sup­ported project, such as a hos­pi­tal or a high­way. The in­come stream be­hind some rev­enue bonds is so sta­ble that ex­perts con­sider these IOUs to be as safe as gen­eral-obli­ga­tion bonds. For ex­am­ple, Co­hen says he thinks rev­enue bonds is­sued by the Los An­ge­les and San Fran­cisco air­port au­thor­i­ties are solid. But rev­enue bonds can be risky. About 90 per­cent of the muni is­sues that de­fault are rev­enue bonds that bet on the health of a sin­gle project, says se­nior an­a­lyst Matt Fabian, of Mu­nic­i­pal Mar­ket Ad­vi­sors, a re­search firm based in Con­cord, Mass.

Com­pli­cat­ing mat­ters for all muni in­vestors is the un­cer­tain fu­ture of in­come-tax rates. If tax rates were to rise, the tax-free in­ter­est that mu­nis gen­er­ate should make the bonds more valu­able. At the same time, some deficit cut­ters are look­ing to cur­tail the muni-in­ter­est tax break. If ap­proved, such a move would un­der­mine the at­trac­tive­ness of muni bonds and al­most cer­tainly hurt their value.

What to do: None of this takes into ac­count what is prob­a­bly the biggest threat to bond in­vestors of all stripes — ris­ing in­fla­tion and in­ter­est rates. Re­gard­less of which state’s bonds you’re buy­ing, the best strat­egy now is to keep ma­tu­ri­ties short, not much more than five years. In early De­cem­ber, a five-year Cal­i­for­nia gen­eral-obli­ga­tion bond, rated sin­gle-A for qual­ity, yielded 3 per­cent. That’s equiv­a­lent to 4.6 per­cent for a high earner out­side of Cal­i­for­nia and up to 5.1 per­cent for in-state res­i­dents. By con­trast, a five-year Trea­sury bond yielded 1.6 per­cent.

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