California Muni Bond Yields Still Appealing

The best time to buy a bond often is when most people think the bond issuer is a lousy credit risk.

Which makes it unfortunate for yield-hungry investors that California is losing its image as a potential deadbeat.

Two of the top three credit-rating firms last week raised their opinion of the state’s general obligation bonds. Moody’s Investors Service lifted its California rating to A2 from A3. Fitch Ratings boosted its rating to A from A-minus.

With the economy picking up, tax revenue rising and a new budget in hand (only 11 days late), the state’s improved financial health merited a credit upgrade, Moody’s and Fitch said.

That’s good news for the Golden State’s reputation, of course. But potential buyers of California tax-free municipal bonds might be wishing they could briefly turn the clock back to just before the recall election that ousted Gov. Gray Davis.

In the summer of 2003, angst over California’s deteriorating finances and political upheaval drove the annualized yield on 10-year general obligation bonds, the type fully backed by the state’s taxing power, to nearly 4.8% that August, well above the 4.4% that 10-year U.S. Treasury notes were paying at the time.

What was wrong with that picture? Interest paid on California bonds is exempt from federal and state income tax. On Treasury interest, investors owe federal tax. So for someone in the 28% federal tax bracket, that 4.8% California muni bond yield was worth the same as a 6.67% yield on a Treasury security -- or 2.2 percentage points more than what investors could actually get on Treasuries.

That kind of yield disparity wasn’t likely to last, and it didn’t.

Today, nearly all new long-term bonds are paying less than those issued in August 2003, a reflection of how anxious investors worldwide have become to lock in decent yields: Demand has been ravenous, allowing borrowers to pay less.

But as a place to earn interest, muni bonds -- and California muni issues in particular -- still are attractive compared with the alternatives. And you don’t have to be rich to think so.

The annualized yield on 10-year California general obligation issues is about 3.9%, according to Bloomberg News data. You can earn more than that in many California muni mutual funds that own a diversified portfolio of longer-term bonds issued by counties, school districts, water utilities and other municipal entities in the state.

California general obligation bond yields are below U.S. Treasury yields once again, but they’re still much closer to the latter than they were, say, in 2000. The 10-year T-note yield was 4.17% on Friday.

At 4%, a tax-free yield in California is worth the same as a 5.88% fully taxable yield, such as on a corporate bond or a bank savings certificate, for a married couple in the 32% combined effective federal and state tax bracket. You’re in that bracket if you earn between $80,693 and $119,950, according to calculations by the California Municipal Bond Advisor newsletter in Palm Springs.

If all of these numbers begin to make your eyes glaze over, focus on the bottom line: If it’s interest income you’re looking for, you have to at least consider muni bonds for your portfolio.

Muni yields have been so appealing that the bonds have been attracting a new breed of investor in recent years, including hedge funds, those go-anywhere investors always on the lookout for opportunities.

Hedge funds and other nontraditional muni buyers have brought more liquidity to the market, and also have helped to push down yields, especially on lower-quality bonds, said Peter DeGroot, a muni strategist at brokerage Lehman Bros. in New York.

But these opportunistic buyers have been so active in munis that many bond pros worry the market is overly dependent on them -- and could be at risk of a sharp sell-off if something triggered their exodus.

That’s what happened in the corporate junk market in May, as some hedge funds and other investors fled amid worries about financial calamity at General Motors Corp.

In the near term, however, it’s hard to see what could trip muni bond demand, said Steven Permut, manager of the American Century California High-Yield Municipal bond mutual fund in Mountain View, Calif. He noted that the expanding economy was boosting state and local tax revenue, enhancing the credit backing of muni bonds (hence Moody’s and Fitch’s upgrades of California last week).

And investors, Permut said, continue to look for yield “wherever they can find it,” which naturally leads many to munis.

One obvious risk to the muni market is the real estate boom. If or when it ends badly, state and local revenue could be hurt. And muni bonds issued to help finance real estate projects (such as infrastructure bonds) could suddenly find a scarcity of buyers.

But one of the most appealing aspects of muni bonds is that the odds of an issuer failing to pay investors what they’re owed are extraordinarily low. Such defaults do happen, but “historically, the default rate on muni bonds has been negligible,” said John Lonski, economist at Moody’s in New York.

For buy-and-hold investors, that means the only serious risk they face in the muni market is the one that confronts all bond investors: If long-term interest rates rise significantly in the years ahead, you’ll feel foolish for having locked in a yield at today’s levels. And if you have to sell your bonds before maturity, you might get less than what you paid.

Still, given the current taxable-equivalent yields on munis, market rates might have to rise a lot to make you regret taking a chance at these interest rates.

And if you’re looking for reasons to be optimistic, remember this: Although California’s credit rating was raised last week, it still has the lowest grade of all the 50 states. If the rating continues to improve, more investors might be willing to buy California IOUs, making existing bonds worth more.

Here are a few issues to consider if you’re in the market for muni bonds:

* Ideally, you’d build a portfolio of individual bonds. But it’s dangerous to do so without help. Michael Glowacki, of the Glowacki Group financial advisory firm in Los Angeles, says he uses professional money managers to build muni portfolios for clients who have at least $500,000 to invest in the bonds.

Investors who try to buy bonds on their own can find that “it’s a shark’s market -- you can get taken,” Glowacki said. Given the huge variety of muni issues, and the disparity in the quality of issuers, only a professional could wade in intelligently, he said.

* If you can’t get professional help with individual bonds, mutual funds are logical choices. The funds offer a way to buy into a diversified portfolio of muni issues and get regular monthly income. The big drawback: Unlike with individual bonds, you can’t lock in a specific yield for a set period. Interest earnings can fluctuate over time as bonds in the portfolio change.

Still, many muni bond funds focus on managing interest payments so that investors don’t face sharp swings month to month, said Dieter Bardy, a fund analyst at Morningstar Inc. in Chicago.

Most important in buying a bond fund, he said, is to pick one with low management expenses, so that more of the portfolio’s income flows directly to shareholders. His favorite picks for California investors: The Fidelity Spartan California Municipal Income fund and the Vanguard California Long-Term Tax Exempt fund.

Besides open-end mutual funds, there are closed-end muni bond funds and exchange-traded muni funds. If you aren’t familiar with them, you’ll need a professional’s help.

* A key question whether you’re investing in individual bonds or funds: How aggressive do you want to be? If you want the highest yields available, you’ll have to be willing to accept higher risk. That risk may stem from the credit quality of an issuer or from the term of a bond (a longer-term issue generally is riskier than a shorter-term issue).

Many muni bonds are covered by private insurance that guarantees interest and principal payments. You’ll earn less on those than on uninsured bonds, but the peace of mind may be worth it.

A good place for both novice and experienced bond investors to go is a website operated by the Bond Market Assn. at www.investinginbonds.com. It has bond basics as well as more in-depth market information.

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What California tax-free yields are really worth

Here’s what California tax-free bond yields are worth to investors in various tax brackets. The taxable-yield equivalents are what an investor would have to earn on a fully taxable investment, such as a corporate bond or a bank savings certificate, to match the tax-free return.

These tax-free yields are equivalent to the taxable yields below:

*--* Effective Joint income marginal 3% 3.5% 4% 4.5% 5% tax rate* $59,401 to $63,850 29.5% 4.26% 4.96% 5.67% 6.38% 7.09% $63,851 to $80,692 31.0 4.35 5.07 5.80 6.52 7.25 $80,693 to $119,950 32.0 4.41 5.15 5.88 6.62 7.35 $119,951 to $182,800 34.7 4.59 5.36 6.13 6.89 7.66 $182,801 to $326,450 39.2 4.94 5.76 6.58 7.41 8.23 $326,451 to $999,999 41.1 5.09 5.94 6.78 7.63 8.48

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* Federal and state tax brackets combined

Source: California Municipal Bond Advisor newsletter

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