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California Here I Come, Right Into A Tax Free Fund

Reading this morning's USA Today article, Roundtable: Is it Time to Shift Out Of Bonds? almost makes me feel bad. The Federal Reserve has bond investors so worked up over interest rates that fund managers are beginning to resemble the collective embodiment of Barney Fife on the Superman ride at Six Flags. The Federal Reserve's December 11th announcement of an endgame to quantitative easing, should the United States reach 6.5% unemployment, sent municipal bonds into a free-fall.

While I don't find myself too concerned we are going to hit 6.5% unemployment by tomorrow, I do have concern regarding dividend tax treatment in 2013. With this concern in mind, I am going to diversify my portfolio with an AMT-tax free bond ETF, which distributes federally exempt dividend payments monthly. I have been looking at these funds for a couple of months, and I believe I have a nice quick pick for investors this morning: California AMT-Free Municipal Bond ETF (NYSEARCA:CMF).

Price: 117.07

YTD Yield: 3.18%

Average Yield-To-Maturity: 1.60%

NAV: $116.00

California AMT-Free Municipal Bond ETF, follows The S&P California AMT-Free Municipal Bond Index. The index is comprised of the investment grade segment of the California municipal bond market, which totals over 1,660 bonds. Each investment grade municipal bond in the portfolio has restrictions on inclusion to the underlying index. Bonds must have a minimum par value of <$25 million and maintain this amount each reporting period, or risk being excluded from the index.

Comparing the price movement of iShares California AMT-Free Municipal Bond ETF to longer duration competitors such as Market Vectors Long AMT-Tax Free Municipal Bond (NYSEARCA:MLN) and Power Shares Nationally Insured Long Municipal Bond Index (NYSEARCA:PZA). The longer duration funds seem to have sharp price reactions to assumed credit risk, such as the Federal Reserve's announcement on December 11th.

(click to enlarge)

Why I Like California AMT-Tax Free Municipal ETF

Here is my pitch: what you give up in geographical diversification, you make up with allocation in historically strong sectors with high credit ratings. In addition to these factors, I believe the duration of the ETF's components, weighted heaviest (40%) in 5-10 year range, provide an additional margin of safety for a income investors, with a longer horizon.

0-1 Years

10.17%

1-5 Years

24.75%

5-10 Years

40.47%

10-15 Years

9.66%

15-20 Years

7.67%

20-25 Years

2.04%

25 Years and Over

4.37%

Average

5.57 years

Cities such as San Francisco (rated Aa2) and Los Angeles (rated Aa3) have seen upgrades by Moody's this past year, signaling signs of what investors hope will be a broader recovery.

Source: Bloomberg

In a article titled: Special Comment: US Municipal Bond Defaults, 1970-2011 Moody's reported that between 1970-2011, Moody's reports there were 71 municipal bond defaults in the United States. The highest concentration of default were in healthcare (32%) and housing (40%), with the least historical risk reported to be in water utilities, transportation and general obligation bonds. Source: Moody's Special Comment: U.S. Municipal Bond Defaults 1970-2011

With CMF's top ten holdings predominantly focused in Los Angeles, the portfolio has a relative margin of safety with high credit debt, funding school districts (9.43%), state wide economic recovery efforts (30%) and water utilities (10.37%).

State and Local General Obligation

32.64

-

30.8

Advance Refunded

11.73

-

4.33

Tobacco

0

-

2.91

Education

17.12

-

9.43

Health

0.17

-

22.07

Housing

0

-

0.82

Industrial

0.05

-

1.46

Transportation

10.05

-

8.93

Utilities

3.01

-

6.84

Water & Sewer

19.32

-

10.37

Miscellaneous Revenue

0

-

0.79

CALIFORNIA STATEWIDE CMNTYS DEV AU

1.63%

5.00

6/15/2013

A1 /A-

LOS ANGELES CALIF UNI SCH DIST

1.42%

5.00

7/1/2013

Aaa /AA-

CALIFORNIA ST ECONOMIC RECOVERY

1.29%

5.25

7/1/2013

Aaa /AA+

LOS ANGELES CALIF DEPT ARPTS ARPT

1.11%

5.00

5/15/2020

Aa3 /AA

CALIFORNIA ST ECONOMIC RECOVERY

1.02%

5.00

7/1/2022

Aa3 /A+

CALIFORNIA ST DEPT WTR RES PWR SUP

1.00%

5.00

5/1/2022

Aa3 /AA-

UNIVERSITY CALIF REVS

0.99%

4.50

5/15/2015

Aa1 /AA

LA CA UNI SCH DIST

0.98%

5.00

7/1/2013

Aa2 /AA-

LOS ANGELES CALIF CMNTY COLLEGE DI

0.90%

5.00

8/1/2017

Aa1 /AA

CALIFORNIA ST

0.90%

5.00

2/1/2014

A1 /AA+

Getting Over the California Hurdle and Investing

California has been a scary proposition for fixed income investors in the past two decades. California has an economy larger than that of many sovereign countries, an economy that does not exactly have the greatest reputation of fiscal health. In addition, California has always had trouble shaking the stigma of the Orange County default of 1994, original New York Times article here: A Default by Orange County.

However, cities such as Los Angeles and San Francisco have seen upgrades by Moody's signaling at least a partial recovery. The index has an optimal duration in terms of inflation and interest rate risk, and seems to be less sensitive to knee jerk reactions to interest rate risk. Overall, I would say this ETF is a good play.

Source: A Tax Free Dividend Fund: California, Here I Come