California tax free municipal bonds have always been attractive to investors in California due to its high state taxes. When an investor combines the state’s individual tax rate of 9.3% with the maximum federal income tax rate of 35%, the combined savings from federal and state taxes of 44.3% is very enticing.
California Muni Bonds Credit Risks
California is a state that periodically gets into fiscal trouble. The state thought it had closed up a $24 billion budget shortfall at the beginning of fiscal year 2009. In November 2009, the governor’s office announced another estimated $20 billion budget shortfall. In the meantime, tax revenues are falling which adds even more pressure to the state government.
Can a major state or municipality go bankrupt? Yes. In 1975 the city of New York defaulted on their muni bonds. The California city of Vallejo declared bankruptcy in 2008. Many investors are scared that the New York City muni bond default will happen again.
However, the phrase “too big to fail” was born during the 2008 financial crisis when the Bush and Obama administrations bailed out the banks, two domestic automakers, AIG, Fannie Mae, and Freddie Mac. How likely will either a GOP or Democratic administration allow California, the 8th largest economy in the world if it were a country, to go bankrupt if it bailed out Citibank, GM, and AIG?
If an investor believes the federal government will not bail out California, then he should not invest in California muni bonds. Many others feel the same way because recent yields on California General Obligation bonds have reached as high as 6% in July 2009, which is a tax equivalent yield of 10.77%. However, those who believe the federal government will bail out California should consider taking advantage of these high yields.
Buying California Municipal Bonds Directly
California muni bonds may be bought on the bond market from many brokerage accounts. However, if one wants to buy an initial offering, he must go to one of the few brokerage houses that have access to those bonds. As of November 2009, the only brokerage houses for initial bond offerings are Barclay’s Capital, Great Pacific Securities, Loop Capital Markets, M.R. Beal, Merrill Lynch, Siebert Brandford Shank, Wedbush Morgan Securities, and Wells Fargo Securities. Although bond offerings are free of commissions, these accounts may have minimum account balance requirements, account fees, and other costs.
When investing in individual bonds, there are many factors to consider such as call risk and revenue backing (sales tax versus utility fees) that may be too complicated for some investors. However, there is an option for those who do not want to invest directly in individual muni bonds.
California Muni Bond Mutual Funds
A much more convenient way to invest in California muni bonds is through a mutual fund or closed end fund. In the mutual fund market, there are California money market funds as well as California bond funds depending on an investor’s risk tolerance. The professional fund managers take care of all the details as to which California muni bonds are the best. California bond mutual funds are available in many brokerage accounts.
With a closed end California bond fund, the investor buys and sells shares on the stock market without the closed end fund needing to buy and sell bonds. This means a closed end fund can hold their bonds to maturity even if a massive number of investors want to sell.
Given the attractive tax equivalent yields on California municipal bonds, investors may want to consider adding California municipal bonds to their portfolio, even though the state’s budget problems are severe.