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?

If income is your primary goal, look for a mutual fund that buys at least some lower-rated issues, Fabian says. Consider quality funds that tip toward the lower end of the investment-grade range -- bonds rated A and BBB. They provide slightly higher income with less risk than a high-yield fund.

He also suggests allocating 20 percent of your bond money to high-yield funds. They paid an average of 6.2 percent over the past 12 months, Morningstar says, compared with 4.2 percent for higher-quality funds.

You have to be able to live with bond funds' volatility. High-yielders are up 15.6 percent in price since Jan. 1. In a poorer market, they could drop 20 percent or more. Assuming you can overlook that little point, you'll reap more income over the years with them than if you had stayed in higher-quality funds.

The trouble is, you may not stick for many years. You might run scared when your fund's value drops. Or you might need the money and have to sell.

In total return -- that's interest plus principal -- high-yield funds have lagged behind higher-quality funds for the past one, three, five and 10 years, according to Morningstar. They put more current income in your pocket but take some of it back when you sell your shares.

If You're Seeking Liquidity

Quality bond funds are the right choice for people who want liquidity as well as income. Pierson favors intermediate-term over long-term bonds. They give you most of the value while reducing the risk. He buys general obligation bonds; revenue bonds backed by essential services, such as water and sewer; and pre-refunded bonds, which are effectively backed by Treasury securities. To juice the income a bit, he looks for downgraded bonds that are still good credits.

National funds, which can buy the bonds of any state, provide better diversification than single-state funds. Those funds are currently picking up bonds from the weaker states, which pay higher interest but aren't likely to default. The trade-off: You may owe state taxes on the income. Your own state's bonds are tax-exempt.

Buying individual bonds is always a question. Individual investors pay more than institutions do and take a haircut in price if they find, unexpectedly, that they have to sell before maturity. Bond ladders work, but keep them short-term, says financial planner Jonathan Krasney of Krasney Financial in Mendham, N.J. You take your risk on the equity side. The fixed-income side is where you play it safe.

Jane Bryant Quinn, author of "Smart and Simple Financial Strategies for Busy People," is a Bloomberg News columnist.

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