California's Broke. Should You Invest in It?

By Jane Bryant Quinn
Sunday, July 5, 2009

Time for some California dreaming: Will the state plug its budget gap, and are its bonds worth a gamble?

Yes, according to Matt Fabian, managing director of Municipal Market Advisors in Concord, Mass. As California hurtled toward its budget deadlines last month, interest rates on its tax-free bonds jumped. Residents can get yields north of 5 percent on intermediate-term general obligation bonds and 6.2 percent on long-term bonds. Nonresidents can buy into the bonds through many national municipal funds, which buy the bonds of many states.

Warren Pierson, senior portfolio manager of the Baird Intermediate Municipal Bond Fund in Milwaukee, says no to the country's fiscally weakest state. But California's credit rating could drop to BBB from A, he says, raising yields even further. "We would then most likely get involved."

The California mess confronts the question of what it means to be an income investor today. Ten-year, AA-rated general obligation bonds, backed by the issuer's taxing power, are yielding an average of 4 percent, down from 5 percent six months ago. To get 5 percent returns now, investors generally need A-rated bonds or lower, or issues that aren't rated at all.

But you face more risk with lower-quality bonds, which leads many investors to seek out a municipal mutual fund for diversification. Owning a portfolio of funds is safer than gambling on just a few bonds.

Defaults on municipal bonds, or munis, rose to record levels last year and might easily rise again. Even so, they're relatively rare. Downgrades are more common, and that's what you have to worry about, says Mary Ellen Stanek, Baird's chief investment officer.

When a credit-rating firm cuts an A-rated bond to A-minus or BBB, the bond's market price plunges. That affects similar bonds that are still rated A but whose underpinnings are weak. The downgraded bond continues to pay its fixed rate of interest, but if you have to sell it, you'll take a loss. If the rating drops below BBB-minus, which is the lowest investment grade, the price drops even more.

Downgrades are just beginning to pour into the muni market. Having run through rainy-day funds, states are reducing subsidies to towns and cities, which are struggling with reduced sales- and property-tax collections. About 48 states face fiscal distress, according to the Center on Budget and Policy Priorities, a situation that will probably continue for the next two years.

Standard & Poor's Ratings Services downgraded 327 municipal issues in the first quarter alone, already exceeding the total of 264 for all of 2008. Illinois dropped to AA-minus from AA. Rhode Island (AA) and Florida (AAA) are on negative credit watch.

And who thinks the ratings firms are up to date on fiscal stress or even have enough information to issue grades? Municipalities aren't bound by the same financial disclosure rules as companies and are notoriously poor at revealing negative information.

If You're Seeking Income

When you think about income investing, what's your priority?

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