California Muni Bonds - Is The Reward Worth The Risk? (Part 1)

For investors who do not know what a municipal bond is, it is a bond issued by a US city or other local government , or their agencies, and the income generated is typically exempted from federal and state tax. Because of the tax incentive, municipal bonds usually have lower yields than corporate or even treasury bonds, as residents for high-income tax states, such as California or New York, do not have to pay any tax on the dividends. For example, for an ordinary California resident, whose state income tax is 9.3% for income bracket over $47,056 (which is nearly any taxpayer in CA), and with a federal income tax income bracket of 28%, a 5% California municipal bond has the taxable equivalent yield of:
versus a corporate bond. Also, municipal bonds default rate was historically very low, making them the investment of choice for many US citizens who want stable income. However, like many fixed income asset classes such as preferred stocks after the financial tsunami, municipal bonds, instead of just providing stable income to investors, suddenly become a trading instrument with the mood swing of a teenager. Even before Meredith Whitney, the famed analyst who forecast the downfall of Citibank, predicted the apocalypse of municipal bonds in December 2010 in her 60 Minutes interview, municipal bonds and bond funds had already taken a dive from its rebound after the financial tsunami. Reasons for the bearish sentiment stem from the diminishing tax revenue resulting from high unemployment, reduced property tax revenue, pension liability, and reduction in tax revenue due to reduced retail activities because of the economy, etc. Besides municipalities, some states, most notably California, New York, and Illinois, have the same problems. There were even talks on bankruptcies for states, but it's really too messy to even contemplate. Not everyone shares the same view with Meredith Whitney, though. Among those who held a different opinion, is the bond kingpin, Bill Gross, of PIMCO, stating that the problems were grossly exaggerated. In fact, he backed his own words by purchasing various PIMCO's closed-end muni bond funds for his personal account, albeit they compose only a small portion of his wealth. While states issued bonds and municipalities issued bonds are different, they are often lumped together in the mind of investors, and bearishness in one category affects the other. Therefore, a state's deficits will influence how investors view the municipal bonds of the state. Also, it is important to separate the different states and look at their problems individually to gauge opportunities in the sector. Among the various states, we think California municipal bonds offer unique opportunities for investors, especially Californian investors, who have the appetite for risks. We will discuss further on this in part 2 of this article. Daniel Ho is the founder of 10xreturn.com, a financial portal providing financial information and market statistics for investment professionals.