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Five Funds to Withstand a California Muni Tidal Wave

For California tax-exempt income with less blowup potential, check out these five CEFs.

Steven Pikelny, 02/27/2012

In recent years, California has gotten a fair amount of attention for issues other than celebrities and sunshine: The words "California" and "fiscal insolvency" have become all but synonymous. With one of the highest state tax rates in the country, Californians face a conundrum. On the one hand, investors at the higher end of the income spectrum could invest in taxable securities and pay up to 10.3% of their investment income in state taxes (on top of the 35% federal tax rate). On the other hand, the bad press surrounding California's budget problems makes the state an unnerving investment option for those considering tax-free income from the bonds issued by the state's municipalities.

A possible compromise is to invest in a national municipal fund, which provides a portfolio of federal tax-exempt bonds diversified across state lines. But such an investment would still leave you subject to most of the California state tax. Besides, default risk is often overestimated, and even a significant uptick in California municipal defaults would not likely be enough to match the default rate of corporate bonds. Should the California municipal market suffer increased volatility (even by municipal standards), closed-end funds, or CEFs, would be an apt fund vehicle for gaining access to the market.

Is California Really Insolvent?
The state's $25.4 billion budget shortfall at the start of fiscal 2012 has been highly publicized, as has the 2008 default of Vallejo, Calif., and the budget problems of Stockton, Calif. Moreover, the state's general-obligation, or GO, debt rating of A- is tied with Illinois for the lowest rating of any U.S. state. However, things are looking up for the Golden State: Vallejo was finally released from bankruptcy at the end of 2011, and Governor Jerry Brown has narrowed the deficit to $9.2 billion through a combination of spending cuts and tax increases.

Last week, Standard & Poor's rewarded these positive developments and changed the state's credit outlook to "Positive" from "Neutral." This indicates a greater likelihood of an upgrade in the near future. Not that California is completely out of the woods: January's revenue was lower than initial projections, and the remaining deficit is still quite large.

Removing default risk from the picture, headline risk could lead to short-term volatility as fickle investors pull their money out of the market and then put it back in. Because the muni market is already highly illiquid, this behavior can be detrimental to open-end funds, where managers have to worry about daily cash flows from redemptions and creations. CEFs would not be affected by this problem from a performance standpoint, but their share prices could still fluctuate in the short term. In fact, long-term investors willing to buck the trend could even benefit from reinvesting their distributions at a discount, if the shares are trading at a discount and the investors participate in their fund's distribution-reinvestment plan.

This does not mean that CEF investors should throw caution to the wind; an ill-positioned or highly leveraged fund, despite a high distribution rate, could still experience a significant depreciation of capital. PIMCO CA Municipal Income II PCK, one of the most highly leveraged funds in the CEF universe, provides the clearest example of this. While many CEFs in its category bounced back from the 2008 financial crisis within two years, PCK still has yet to reach its 2008 high. As such, we have focused on CEFs that pay compelling tax-exempt distributions but that also, in our opinion, have less potential to blow up because of their leverage under extreme market conditions.

Invesco CA Quality Municipal IQC

Although its 5.9% distribution rate at share price is marginally lower than the 6.0% California municipal CEF peer group average, its 1.41 leverage ratio (total assets/net assets) is also lower than the 1.55 peer average. What's more, the fund's undistributed net investment income, or UNII, of $0.2832 per share gives the fund about four months' worth of coverage on its distribution. For investors concerned about the Alternative Minimum Tax, this fund still fits the bill, as only 3.9% of its portfolio is not exempt from the AMT. Furthermore, the fund's fiscal 2011 adjusted-expense ratio of 0.35% was well below the California municipal CEF average of 1.17%, making it one of the cheapest options for investors to gain access to the California municipal market.

Steven Pikelny is a closed-end fund analyst at Morningstar.

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