California Muni Bonds To buy or not to buy...

This is a brief look at the California Muni Bond market. The bulk of this article will be focused on the subject that is near and dear to every bond investor, whether you are located in California, New York or anywhere in between. I will not go into any great detail here as this is just a brief overview foccussing primarily on California. Happy Reading, Keith A. Campbell

 

California Muni Bonds...to buy or not to buy...

 

Mr. Jacobs (no relation to the real Mr. Jacobs) has decided to purchase California Municipal Bonds, but is worried about the largest economy in the fifty states. The word DEFAULT looms up ahead like a make shift road sign on a long winters night...”Warning Bridge Out, Turn around.”

 

Mr. Jacobs looks at those fat yields, calculates what tax free really means to him, and it means a lot when he has been paying 9.3% state income tax.

 

So how much risk is there in investing in California Municipal Bonds?

 

That's the big concern in Mr Jacobs mind. What are the chances my bonds will default. When speaking of Muni bonds, one would have to drop down to Ba/BB rated junk to get a likelihood of one percent, according to data from Moody's and Standard & Poor's.

 

If Mr. Jacobs is still unconvinced, there are plenty of double A rated and insured bonds he can pick and choose from. Now we get to default rates far lower than one percent.

 

Now if one were to ask Martin Weiss of Weiss Research, he will tell you, as sure as the sun sets, California will default on some of its debt obligations. That almost sounds like a get out while you can type of warning. Of course the Obama administration could very well step in and help bail out our huge economy here.

 

Mr. Jacobs head is probably spinning now, wondering why anyone would invest in California. If you are like Mr. Jacobs and many other investors the word default is nearly synonymous with bankruptcy, however it is far from that. A bond issuer does not have to fail to make a monthly coupon payment, or fail to repay investors when their notes come due. While all of that could happen, and it certainly means default, a bond can be in default if the issuer is as little as a week or so late paying their current coupon payments.

 

Municipal bonds have a pretty high recovery rate at about 68 percent. Recovery may come in a couple forms. One, the borrower my catch up on debt service payments, or liquidate collateral securing the bonds.

 

If Mr. Jacobs has decided to go ultra conservative he will have purchased insured bonds so that if one of the issuers of his bonds comes up short the insurer will step up to the plate and make a timely payment.

 

That is not to say bond prices will not drop, they probably will, as there could be a flight to quality-US Treasuries, or even to money market funds. Your risk here is that if you needed to cash in on your bond prior to maturity date you are not going to be happy with the price you get.

 

On the upside, if you have issues come due you are likely to be able to reinvest at a pretty deep discount. However, if you will just wait a bit longer before pulling the trigger you may come up with an even better price. And that too is a problem. Investors keep coming in thinking they've gotten a good deal only to find a better one a week later. If one is trading bonds here you will likely have a tough time in California. Just when you thought prices had bottomed out, they get hit again and again. While California's fiscal crisis is real, it is in their best interest to play up the ongoing calamity so they catch the ear and the deep pockets of the Obama Administration. `

 

I believe in California's Muni bonds and with a little research and diversification one can take that .03 percent chance of default and drop that to near if not a zero percent chance of default. California's General Obligation bonds are secured by the full faith and credit of the United States Government. Now can you really go wrong here?

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Comments

  • Doralynn

    July 22, 2009

    Great article... funny and informative. I'm impressed... especailly since I'm a financial illiterate. DL

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