Market Overview

California Muni Bonds - Is The Reward Worth The Risk? (Part 3)

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CaliforniaTo invest in California municipal bonds, an investor can consider the following investments:

1. Individual municipal bond

Brokers from major brokerage houses often recommend municipal bonds to their clients, particularly when their brokerages are the underwriters of those bonds. Every major brokerage firm also has their own bond desks, and investors can inquire information on any upcoming for secondary bond from them.

Evaluating the risk of an individual municipal bond is not an easy task. The financial health of the county or agency which issued the bond; the source of revenue that will service the interests and repay the bond; whether the bond is insured, etc. are just some of the considerations an investor should have when purchasing an individual municipal bond.

Also, like most fixed income instruments, liquidity for a municipal bond is often very poor, where bid and ask prices are wide apart, and trading is far and few between. An investor must be aware of this.

2. Municipal bonds mutual fund

Many mutual fund institutions such as PIMCO, Nuveen (NYSE: NUV), BlackRock (NYSE: BLK), Fidelity, etc. offer California municipal bond funds. The funds basically do all the homework for investors in evaluating the muni bonds and select the bonds into the funds. Like any mutual fund, track record of the fund manager often makes a difference in the return of the funds.

There are many different kinds of bond funds, and their risk profiles are also different. Unlike a bond, a municipal bonds mutual fund does not have a maturity date, and investors can make or lose money when they sell the mutual fund, and will have to pay capital gain tax even though they might not have to pay tax on the interests they receive from the fund.

3. Closed-End Municipal bond fund

Closed-End municipal bond funds are similar to muni bonds mutual funds, but their initial capital is fixed, and then get managed through that capital base. Like ETFs, they are also traded on the exchanges, making them more suitable as a trading instrument if so desired. Closed-End funds sometimes use leverage to juice up their returns.

By having a portfolio of bonds in a municipal bond fund, the risk of defaults is spread among the portfolio. For most investors, this would be a much better way to invest for those who are income focused, and do not have the expertise and risk appetite to deal with individual bonds.

When Bill Gross invested his personal money in California municipal bonds, he purchased five PIMCO's closed-end muni bonds funds: (NYSE: PCQ), (NYSE: PCK), (NYSEL PZC), (NYSE: PMX), and (NYSE: PMF). Most of the holdings of these funds are in longer-term CA muni bonds, with ~20-30 years till maturity, and the yields on these funds are far superior to treasury these days.

Consider PIMCO's California Municipal Income Fund (NYSE: PCQ): Even though the yields have fallen since Mr. Gross bought it, it is yielding ~7.5% right now compared with 30 yr treasury of ~4.25. For Californians who fall within 9.3% state income tax bracket and 28% federal income tax, the taxable equivalent yield would be

7.5% ÷ (1 - (9.3% + 28%)) = 11.96% for PCQ

verus

4.25% ÷ (1 - 9.3%) = 4.69% for 30 year treasury bond

* For some rich Californians who have the highest federal tax bracket of 35%, the tax equivalent yield would be: 7.5% ÷ (1 - (9.3% + 35%)) = 13.46% for PCQ

We can see that there's a huge discrepancy between the yields for Californians with just ordinary income. This is certainly due to the risks in California's deficit and its structural problems. Nonetheless, California could have better than expected income tax revenue due to all the technology companies' IPOs, and governor Gerry Brown had shown the determination to balance the budget, we believe the reward for investors in California muni bonds is worth the risk, particularly for Californians. Unless many municipalities started to default on their obligations, we believe the downside risk for California muni bonds based on economic predictions might be exaggerated. However, there are other risks for municipal bonds which we will discuss in the next part of this article.

California Muni Bonds - Is The Reward Worth The Risk? (Part 1)
California Muni Bonds - Is The Reward Worth The Risk? (Part 2)

 

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Posted-In: california municipal bondsLong Ideas Sector ETFs Bonds Dividends General

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