Time for California Muni Bond Investors to Take a Stand

By Murray Coleman

Enough is enough. I’ve had it with California muni bonds.

Despite the relative safety of holding the state’s debt in the form of index funds or ETFs, when a government starts paying for prison services and laundry bills in the form of IOUs …

Don’t get me wrong. It’s not time to panic and completely bail on the state’s bond issues. If you’ve held onto them up to this point, jumping out all the way might not be the best idea. After all, long-term returns of conservatively run, ultralow-cost mutual funds like the Vanguard California Intermediate-Term Tax-Exempt Fund (VCAIX) are stellar.

The story is similar with ETFs. (We took a look at the muni bond ETF field last year in this column).

In California, one of the more popular options is the iShares S&P California Municipal Bond ETF (NYSE: CMF). So far this year, it’s up more than 2.4%. And it’s paying a tax-equivalent yield for someone in the upper brackets of around 6.6%. That compares with a slightly negative return on the iShares Barclays Aggregate Bond Fund (NYSE: AGG) and taxable yield of about 4.4%.

But in the past three months, while AGG has held its own during a rally in stocks, CMF has faltered. Its total returns are negative for the period, underscoring how quickly conditions have changed. Sentiment has been on a roller coaster this year toward California’s debt situation, which now is around $24 billion. Earlier, investors were relieved by signs that politicians would take advantage of improved market conditions to wiggle out of their fiscal deficit hole. Lately, conditions have turned worse and the legislature seems deadlocked down party lines.

A few weeks ago I wrote a bullish comment over at Bogleheads supporting the view that it was highly unlikely the state would go bankrupt. ETFs like CMF and the SPDR Barclays Capital California Municipal Bond ETF (NYSE: CXA) track benchmarks steeped in high-quality bonds that are guaranteed by the state’s general obligation fund. California Treasurer Bill Lockyer has said that only “thermonuclear war” could halt payments of bonds with such backing.

Still, is there anyone out there investing in California munis who hasn’t sold at least part of their positions in the face of the state’s latest bumbling? I never in my wildest dreams imagined that the eighth-largest economy in the world would ever fall into such disarray.

New Twist On Trickle-Down Theory

And now, the state is issuing IOUs to even the most common of creditors? Think about that for a bit. I’m Joe Blow and I own a small landscaping service. It’s tough times, but I’ve managed to win a bidding war for a state contract to take care of a bunch of state office sites. I keep my costs lean and even though the price given to the state was very low, there’s a bit of profit to help with cash flow. Now, I’m getting paid with IOUs?

Besides the absurdity of the situation, what’s going on with California smacks at the very basis of sound investing practices. I consider myself an investor. I take pride in the fact that part of the hard-earned money I bring in each month goes into investing in our economy and others around the world. It feels good to invest in good companies and good places where people work hard and try to get ahead.

I’m not a Democrat or a Republican, so don’t think this rant is political in nature. But there’s a fine line between being a prudent investor and remaining true to your basic reasons for putting money into bonds. I’m in the accumulation phase of my investing life, where bonds are around to smooth my family portfolio’s bumps in a supposedly more volatile stock market. Is 2-3% more in tax-protected yields worth staying invested in a state that the Wall Street Journal recently observed has become ungovernable? (And that was in a front-page news story, not an opinion piece.)

So while I’m not bailing out completely from my California muni bond fund, I am trimming aggressively. This is designed to kill two birds with one stone. First, it’ll hopefully diversify my bond portfolio greatly. I’ve been extremely lean on Treasury Inflation Protected Securities, and now seems like a good time to start stocking up as part of a longer-term strategy of devoting part of my allocations to fighting rising prices.

But shifting part of my allocation away from California munis also lets me rest easier at night knowing that in my own way, I’ve made a statement. I’m not a politician, and a vote of the people is still far down the road. Still, through my ownership rights as a bondholder in the state’s crazy bureaucracy, I’m able to take a small stand. Enough is enough.

For me, the expansion of ETFs and index funds into more and more parts of fixed-income markets is turning out to be more of a democratizing investment process than I ever imagined. Holding onto some California munis will let me reap the rewards of whatever convoluted solution results from all of this latest mess (and I’m confident there will be a solution … eventually), and will also keep me invested in my state’s economic future.

But it sure feels good not to be quite so beholden to the whims and fancies of our elected leaders in Sacramento. Who said diversification isn’t working these days?

Original post

Comments

[Mad Hedge F...:]

Who can blame you? As the California budget battle reaches white hot temperatures, Fitches has cut the rating on the state’s debt to A-, and placed it on “credit watch”, a warning of further downgrades. The move is a delayed recognition of reality, as is the rating agency industry’s practice. The legislature tried, but failed to pass $12 billion in budget cuts, which governor Arnold Schwarzenegger said he would veto anyway, because they didn’t meet the full $24 billion tab (see my previous dispairing piece at www.madhedgefundtrader.... In the package were increases in motor vehicle registration fees, $1.50 a pack in additional tobacco taxes, cancellation of health insurance for one million children, a production tax of 9.9% for in-state pumped crude oil, the firing of thousands of teachers, firefighters, policemen, and probation officers, and more smoke and mirrors accounting shenanigans that kick the can into the future. Some of the changes were only possible through a redefinition of the English language that turned “taxes” into “fees.”As California goes, so goes the nation, as many states will follow the Golden State into financial Armageddon. In a new era of soaring unemployment, restrained consumption, high savings, and crashing stock and property prices, states dependant on taxes on incomes, sales, capital gains, and property appraisals don’t do well. Make sure those muni bonds are insured. Why do I get the sickening feeling that I am watching a rerun of Thelma and Louis?

Jul 01 09:56 AM

[No Free Cake:]

California is clever. The IOU's are a much cheaper way to borrow money than to issue new bonds. Heck, they even said they might allow you to pay a variety of bills with the IOU. Sort of like printing their own money. Like I said, very clever.

Jul 01 10:00 AM

[ValueBarbar...:]

Of course it's very unlikely that California will go bankrupt. Remember...State's CAN'T seek bankruptcy protection.

However, they can DEFAULT.

I can't imagine jumping into these OF ALL bonds. You're taking a lot of risk here, and not getting paid a lot for it. I'd rather buy a volatile dividend payer that pays 6% than hold California bonds that will only avoid huge losses if the economy miraculously turns around. I've been tempted to make a bearish bet on California muni's for some time, but perhaps you're right and I'll just watch as you ride this investment train to glorious 6-7% returns.

Jul 01 10:04 AM

[Lilguy:]

You may be late to the TIPS pot--at least for the appreciation--but you're wise to cut back on Ca. munis.

I share your views on investment: looking for opportunities to make a fair return based on hard, smart work in well-managed entities. Now, after 40 years, I am finding that those US stock market "opportunities" in the US are increasingly, if not predominantly, manipulated at the exchange by machine trading, the books of the companies I've researched are totally cooked, the regulators who are to keep this all in balance are stupid, lazy, and corrupt, and now the economy as a whole is deteriorating at an unprecedented pace, led by the substantial disappearance of the American middle-class that has been the backbone of the country's growth.

So, while you are shifting out of Ca. munis, I have shifted out of stocks and don't plan to return until the playing field is level, transparent, and robust.

Jul 01 10:40 AM

[Crank Monkey:]

While California is the poster child for bad government, it's standard practice for states to underfund pension obligations. This makes me wary of their bonds.

Jul 01 10:57 AM

[Alan Young:]

Whine, whine. Everyone wants their phat returns-- and 6.6% tax-free is pretty phat -- but no one wants any risk to the principal. Well, guess what: you can't have it both ways.

If you're in the accumulation phase, the short-term behavior of the asset shouldn't matter. Hold the dam' bonds while the market panics about California's nasty politics, and tough it out. In a year or two, they will be worth a lot more.

Actually, I sold all my CA bonds months ago, because I saw this coming and thought the market would price them much lower-- which it hasn't significantly done (yet). But I'm older and can't afford to wait out a downturn.

Jul 01 10:58 AM

[User 357705:]

The Journal was only partly right about the ungovernable. Its not just CA, its all of USA that is ungovernable.

Jul 01 11:10 AM

[Bull Run:]

If only California could print it's own money, like the Feds, then all would be saved. The number one industry in America, the printing press. It's not just California that is bankrupt, many states are facing budget shortfalls and muni and UI payment problems. It's all across America. A working class that's unemployed, homeless and without healthcare. A retired population which has lost much of it's retirement plans, and comp. beneifits. A middle class that has a negative net worth. Divorces are not fighting over assets, but are dicussing who's responsible for what debt and who pays. Many of America's major comp. are in serious financial trouble, looking for the next bail-out, and that includes America's banks which are basically insolvent, but running on free printed money. In retrospect California's problems just are a reflection of America's problems.

Jul 01 11:22 AM

[OldNavySailor:]

The fact that California is issuing IOU's as a substitute for payment for contracted services is a violation of Article 1, section 10, clause 1 ("Contracts Clause") of the United States Constitution; to wit:

"No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility."

These IOU's are nothing more than Bills of Credit, which is prohibited by the Constitution. They can make gold or silver coins as a tender of payment, but not an IOU (see Craig v. Missouri, 29 U.S. - supreme.justia.com/us/.../)

Jul 01 12:18 PM

[Annualgain:]

Next area of speculative investing: Buying CA state IOUs at $0.50 on the dollar.

Jul 01 12:41 PM

[Jeff Nielson:]

A very well-written, well-balanced commentary. However, I will warn the author about one fact. The same group of liars who claimed that this economic collapse would NEVER occur (remember Bernanke's FIRST two lies: the "Goldilocks economy" and the "soft landing"?) are ALSO the same people predicting "economic recovery".

When these latest lies are exposed, those such as yourself who retain optimism for the future are going to have totally revise those conclusions.

OldNavySailor, excellent observation about how California IS (in its own way) "printing money" to (pretend to) pay its bills - and violating the U.S. Constitution.

Sadly, this is the SAME "constitution" which REQUIRES U.S. "currency" to be defined (and redeemable) as a measurement of SILVER.

Ultimately, precious metals remain the best "insurance policy" for the dark DECADES ahead.

Jul 01 01:18 PM

[yellowhoard:]

Other than perhaps Texas and North Dakota, I can't think of any state bonds that I would feel comfortable with.

As property tax revenues plummet and sales tax revenue does the same, every state is only months away from crisis.

I don't think most people have realized yet how ugly this thing is going to get.

Jul 01 01:30 PM

[Craig W:]

It's none of my business (for now) as I live in a "fly-over" state, but if I were a resident of California, I would be demanding the state treasure to pay all elected officials and political appointees with IOUs until they get the budget balanced. Now I say that it’s none of my business for now because I fear the Feds will make it my (our) business the same way they made banks and auto makers my(our) business.

On another note, LilGuy says " . . . I have shifted out of stocks and don't plan to return until the playing field is level, transparent, and robust."

I wouldn't hold my breath that that day will come anytime soon.

Jul 01 02:05 PM

[bcncv:]

California is a complete fiscal mess, and it's not going to get any better. The political interests are too deep in their positions for substantial change or negotiation.

I fully believe the politicians will stick to their status quo of voting to pay for "good" things with money that doesn't exist. Their incentives are set up to reward them (votes) for putting the state in default. By cutting services they will lose their jobs in the next election.

Don't fret though. Do you really think that a democratic executive and legislative branch will let any serious harm befall their largest single dedicated voting block? The feds can't say no to that.

Jul 01 02:28 PM

[Zenfar:]

I thought only the Federal government could print money. The IOUs can not be used as money, or else CA would be printing money.

Jul 01 02:30 PM

[grey road:]

only the FED can print money, not the fedral government.


On Jul 01 02:30 PM Zenfar wrote:

> I thought only the Federal government could print money. The IOUs
> can not be used as money, or else CA would be printing money.

Jul 01 04:48 PM

[User 357705:]

Only the TREASURY can print notes.

Jul 01 04:56 PM

[HardwoodFlo...:]

MAd Hedge Fund Spammer- You stole that Thelma and Louise comment from CNBC!

Jul 01 04:58 PM

[whidbey:]

Yellowhoard is the man.

The pain in states is coming from all directions and they have no tools for coping. The dive is out of control. So round two is the failure of state economies. But wait! there is more, the commercial RE is in real trouble, the banks are cutting off credit cards to consumers and the green gets whacked hard.

Default or inflation is the choice and neither one works for the common man, but who cares for him anyway?

Jul 01 06:22 PM

[User 422955:]

This may be another article on which the SA editors put a misleading title. The author refers only to bonds from the CA state governments. He is not referring to CA munis issued by local governments, school districts, or special purpose districts. If my understanding is not correct, please post a correction. thanks.

Jul 01 09:00 PM

[a fat panda:]

You aren't investing in California bonds. You are betting that the government will help them out in some way. This is the same as people who 'invested' in banks last December or 'invested' in autos a month ago. I can't tell you how or whether the Federal government intervenes. I can tell you that if it does these bonds are a better investment than what underlies the intervention - US Treasuries.




On Jul 01 10:04 AM ValueBarbarossa wrote:

> Of course it's very unlikely that California will go bankrupt. Remember...State's
> CAN'T seek bankruptcy protection.
>
> However, they can DEFAULT.
>
> I can't imagine jumping into these OF ALL bonds. You're taking a
> lot of risk here, and not getting paid a lot for it. I'd rather buy
> a volatile dividend payer that pays 6% than hold California bonds
> that will only avoid huge losses if the economy miraculously turns
> around. I've been tempted to make a bearish bet on California muni's
> for some time, but perhaps you're right and I'll just watch as you
> ride this investment train to glorious 6-7% returns.

Jul 01 11:13 PM

[Mr. Ed, Jr.:]

The CA legislators have started to make big sacrifices in their own compensation. Sure, they have helped themselves to the highest pay package in the country, but they are now making a serious effort, such as this:

Effective this year, legislators will have their health insurance allotment of 2 free pair of prescription glasses per year (or sunglasses, if they do not wear prescription glasses) reduced to 1 free pair annually.

That is a 50% reduction. Real evidence of empathy with their fellow citizens.

If this wasn't going to hurt so many people, it would be funny. "Stupid" funny. Like that TV show, "America's Dumbest Criminals".






On Jul 01 02:05 PM Craig W wrote:

> It's none of my business (for now) as I live in a "fly-over" state,
> but if I were a resident of California, I would be demanding the
> state treasure to pay all elected officials and political appointees
> with IOUs until they get the budget balanced. Now I say that it’s
> none of my business for now because I fear the Feds will make it
> my (our) business the same way they made banks and auto makers my(our)
> business.
>
> On another note, LilGuy says " . . . I have shifted out of stocks
> and don't plan to return until the playing field is level, transparent,
> and robust."
>
> I wouldn't hold my breath that that day will come anytime soon.

Jul 02 02:31 AM

[readuntil:]

Should I sell BCLTX and VCAIX?

Jul 02 10:28 AM

[Missing_Link:]

Good article. Sold all my muni bonds a month ago when I found out they had 5-10% exposure to Califonia. Definitely one of my better decisions.

Jul 02 11:01 AM

[Danny Newton:]

Maybe the state could sell their own carbon allowances before the federal government takes that over.

Jul 02 12:14 PM

[Northstar10000:]

I stopped reading your article once you said no reason to be completely out of the California Paper. Why in creation would you want only part of your money going down the toilet? Why not leave it all there do you can get the complete effect. With hundreds of thousands of possible investment choices you can't do better than California Dreaming???? Man you got to get away !!!!

Jul 02 11:00 PM

[ejhickey:]

I wonder if the following scenario is possible.

California defaults on it's General Obligation bonds. Then the Federal Government decides to do a bailout for California and a reorganization of their finances. as part of this process, the decision is made to change the priority of the bondholders. Another possibility is the Feds decide to cancel all of the state's bonds and offers the holders 50 cents on the dollar. After the Chrysler Bankruptcy, I believe something like this might happen in regards to California Muni Bonds

Jul 03 12:14 AM

[2contango:]

Unfortunately, the majority of state legislators owe their jobs to public employee unions. There's nothing inherently wrong with unions. Their job is to advocate for the best short-term interests of their members. So they won't permit legislators to make the cuts necessary to truly bring spending in line with revenues.

The minority ideologically opposes any tax increases on any grounds.

The legislature may come up with a short-term fix, consisting as usual of accounting tricks, but the only realistic future for California is bankruptcy. Even some legislators privately admit that bankruptcy is preferable to having to make painful choices.

Jul 04 12:23 PM