Advice for California Muni Bondholders

Remember when municipal bonds were boring? California muni bondholders can be forgiven for feeling nostalgic for those days. Coupon-clippers from Eureka to San Diego have had to watch as the triple-A rating on their insured bonds evaporated, as California's credit rating fell to the lowest level among the states, and as their elected leaders proved incapable of closing a massive budget deficit.

The headlines are scary, to be sure. But in most cases the interest payments and principal you're owed on California bonds are safe, even if the legislature doesn't come up with a budget solution by the July 1 deadline legislators have pledged to meet. Still, some issues are safer than others, and some defaults are undoubtedly on the way.

At the top of the safety pecking order sit general-obligation bonds, or GOs, issued by the state itself. "By constitutional amendment, the general obligations get paid prior to other programs, state employees or any other obligations, with the exception of redistributed property taxes that go to schools," says Daniel Genter, who manages muni portfolios for RNC Genter Capital Management, the Los Angeles-based firm he heads. "Not paying on those is just not an option for California."

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Bonds backed by the revenues of essential services, such as water, sewer and power providers, should also be secure. "Even in hard times people will pay their electricity bills," says Warren Pierson, co-manager of the Baird Intermediate Muni Bond fund. Also safe are pre-refunded muni bonds, which are backed by Treasuries held in escrow.

For GOs issued by a city, location is key. Holding debt from a town at ground zero of the housing bubble? That could be worrisome. Other potentially problematic paper: Any bonds related to industrial development, health care or housing.

A few Web searches on your bonds' issuers can go a long way. "Somebody showed me a bond recently from a school district in California," says Pierson. "I pulled up the district's Web site and on the home page there was an update on that school district's financial crisis. That was as far as I needed to go." Thomas Doe, founder and chief executive of Municipal Market Advisors, a Concord, Mass., muni-bond research firm, adds that investors should monitor trades of bonds they own on MSRB.org or InvestinginBonds.com. Sudden price movements could clue you in to any new developments on the health of your bonds' issuers.

History doesn't provide much guidance on what bondholders can expect in a worst-case situation, in part because muni defaults are so rare. New York City defaulted on its bonds in 1975, but creditors who held on to their paper eventually got back all of their principal and the interest they were due. Investors holding GO debts of the city of Vallejo, Cal., which filed for bankruptcy in 2008, have so far continued to receive interest payments without interruption. Of course that could change, depending on the outcome of the city's negotiations with its police and firefighter unions.

Speculation abounds that Uncle Sam, who has been so generous rescuing banks and automakers, may ride to California's rescue. But Pierson, noting the outcome of the Chrysler bailout, says federal assistance may not be a blessing for bondholders. "The government said it thought bondholders ought to share in the pain," he says, even if clipping bondholders meant overriding standing contract law.

But for most bonds, a ratings downgrade, rather than a default, is the more pressing risk. "I don't sense that the credit-rating agencies have sat down and digested how much the municipal landscape is changing," Pierson says. "States that may not have had a deficit two years ago now have deficits." More ratings downgrades are in the mail, he warns, and that will knock down the prices of existing debt. For this reason, you should own individual bonds only if you plan on holding them until maturity and you don't mind watching their prices fluctuate in the secondary market.

The bottom line: Know what you own, and know where the money for your interest and principal payments is coming from. If you can't figure that out for all the bonds you own, you need to seek out an expert who can.

Owning muni bonds is "a bit like loaning money to a relative," says Genter. "You really want to know what they're going to use the money for and how they're going to pay you back. And you have to acknowledge that you have little recourse if they choose not to pay you back."