Despite state’s woes, muni bond market hasn’t cracked

This article was originally on a blog post platform and may be missing photos, graphics or links. See About archive blog posts.

California may be broke, but many investors so far are happy to stick with the state’s bonds, trusting that debt repayment will be a priority at the expense of other spending.

Investors’ willingness to stay put with tax-free California bonds shows in the share prices of major mutual funds that own debt of the state and its cities, counties and other municipalities. The market value of many of those portfolios continues to climb despite the dire headlines.

Case in point: Shares of the $2.8-billion-asset Vanguard California Long-Term Tax-Exempt fund on Wednesday rose 3 cents to $10.84 -- their highest level since late September -- one day after the state’s voters rejected measures aimed at easing the budget crisis.

The municipal bond market overall suffered two severe sell-offs in the fourth quarter of last year as the global credit crunch worsened and investors fled from risk. But the market has rallied sharply this year as yield-hungry investors have jumped back into munis.

Even though tax-free muni yields have dropped from their 2008 peaks, they’re still attractive relative to yields on many taxable bonds, including U.S. Treasuries.

The annualized yield on 10-year California state general obligation bonds, for example, has fallen to 4.40% currently from a high of 5.34% last October, according to Bloomberg News data. But it’s still far above the 3.2% yield on 10-year Treasury notes.

Investors also may be comforting themselves with historical data on the muni market that show very low default risk.

‘What the market is telling us is that long-term investors believe [California] is going to figure out how to pay its debts,’ said John Carbone, manager of the Vanguard California fund.

Or to put it another way: Greed has the upper hand over fear at the moment, the reverse of the market’s situation last fall.

Could muni bond owners be too complacent about the outlook?

George Strickland, manager of the Thornburg California Limited-Term Muni fund, believes that the marketplace is likely to begin demanding higher yields on the state’s bonds as the budget crunch intensifies and the state seeks to sell up to $20 billion in short-term debt to raise cash this summer. A jump in yields would drive down the value of existing bonds, potentially reversing some of this year’s muni rally.

As for default risk, with the state’s general obligation bonds -- the ones issued to pay for infrastructure projects -- repayment of principal and interest is mandated by the state Constitution. That’s about as iron-clad as you can get.

But the safety of bonds of cities, counties and other local issuers is much harder for the average investor to discern. That will only become more of a concern as the state reverts to raiding locally destined funds to patch its own budget gap.

‘We’re watching those credits very carefully,’ Strickland says of local bonds.

Many buy-and-hold investors prefer to own individual muni bonds rather than funds, which I fully understand. But at a time like this, the diversified-portfolio approach of a mutual fund can offer much more peace of mind to people who don’t have the wherewithal to evaluate the creditworthiness of individual muni issuers.

‘Know what you own’ has never been more important advice for California muni investors.

-- Tom Petruno