Will Your California Muni Fund Get Clobbered?

In recent months, I've gotten plenty of e-mails from readers wondering how California's budget crisis will impact their muni fund. I can't say I blame them. Investors in high-quality long-term muni funds were treated to worst-ever losses in late 2008, which is enough to make anyone a little wary. And although the muni market has stabilized somewhat this year, it's tough not to notice the toll the recession is taking on many municipal issuers. In hard economic times, corporations have the financial flexibility to sell assets, pay down debt, or raise equity. But state and local governments have little choice but to offset declining tax revenues with a combination of service cuts and tax and fee hikes. Even when the writing is on the wall, those are unpopular steps that invite political posturing.

California Screamin'
Nowhere are these political challenges more evident than in the barrage of nerve-wracking headlines out of Sacramento, California. The combination of a severe economic downturn and a highly dysfunctional political process left the state with a $26 billion-sized hole in its budget when its fiscal year got underway on July 1. Lawmakers had managed to close a $40 billion budget gap (its largest ever) in February, but the state's revenue projections proved too rosy, and some of the fixes too ephemeral. With no resolution forthcoming as the fiscal year got underway in July, the state issued IOUs to pay contractors and tax refunds, and mandated more unpaid leave for state workers.

Late budgets are nothing new in California, but this standoff has caused some to worry that the state could default on its debt, or that more downgrades are on the way. First Fitch and then Moody's dropped ratings on the state's debt to BBB and Baa1, respectively (down from A- and A2), bringing it closer to junk status. On Tuesday night, Governor Schwarzenegger and lawmakers struck a deal that would include $15 billion of spending cuts. The remaining $11 billion will be made up with temporary plugs like borrowing money from local government coffers, shifting money between accounts, and fudging pay dates. So, even if the proposed budget is passed by a two thirds majority in the legislature, the inclusion of one-off fixes and accounting gimmicks promises more political theater down the line.

The state's political quagmire has been exasperating. When an online poll at The Wall Street Journal asked, "Is California ungovernable?" in late May, 73% of respondents said yes. At best, retail mutual fund investors appear nonplussed. While they shoveled close to $30 billion into muni funds in the first half of 2009, according to Morningstar Fund Flows data, funds that invest primarily in California bonds have been the only subgroup to see modest redemptions this year. Investors have pulled nearly $500 million out of California muni funds so far, representing 1% of the group's total assets at the end of 2008.

Able to Pay, and Likely Willing
Sacramento's budget standoff may make you want to bang your head against a wall, but it's not necessarily catastrophic for your muni fund. Fund managers we've interviewed overwhelmingly agree that the likelihood of the state defaulting is tiny, and several fund companies, including BlackRock, Franklin, Nuveen, and Vanguard have published commentaries that make the case. While Chapter 9 of the federal bankruptcy code allows municipalities to file for bankruptcy protection, it doesn't afford states the same relief. Also, payments on the state's general obligation bonds are constitutionally mandated, ranking second only to spending on public schools. These obligations are a "continuing appropriation," meaning the Controller doesn't need action from the state Assembly to make payments. The size of this year's GO debt service payments, at around 5% of expenditures, doesn't appear particularly onerous, either.

Then there's the deterrent of higher financing costs to keep the capital markets-dependent state honest. Rafael Costas, co-director of Franklin's municipal-bond team, noted in a recent interview that California bonds have already paid an extra 150 basis points or more in yield over the highest-rated alternatives this year, and that's before the latest downgrades. If the state missed a bond payment, he thinks the market would demand multiples of that in extra yield for many years to come. In addition, if the state were downgraded to junk status, it would be unable to sell its bonds to the many mutual funds with investment-grade-only mandates. That, too, would cost the state big.

Now, take a step back. Even if the unthinkable happens, there's much more to California muni funds than the state's GO bonds. One of the more conservatively run funds of the group,  Vanguard California Long-Term Tax-Exempt (VCITX), had just 10% of assets in the state's GOs as of March 31, while most of its peers had 5% or less. The $13 billion behemoth of the group,  Franklin California Tax-Free Income (FKTFX), currently holds a mere 2% of assets in California GOs, with the rest of the portfolio spread across more than 800 individual bonds issued by local governments, school districts, public utilities, hospitals, toll roads, colleges, and more.

Trouble Where You Most Expect It
Although investors shouldn't let scary headlines coming out of states like California, New York, Florida, Michigan, and Ohio (the list goes on) send them scrambling, the reality of deteriorating fundamentals is likely to impact the muni market for some time to come. Given the severity of the recession, more managers and analysts are telling us they expect defaults to rise above historical norms. And because economic downturns hit municipalities later than other segments of the economy, municipal-bond issuers have yet to face the full brunt of the recession.

Still, few managers are concerned about the viability of most tax-backed GO debt, or bonds financing essential services like water and sewer utilities. Even in the rare event of a default, bondholders have managed to recover most, if not all, of their investment in these sectors. After Orange County, Calif., filed for bankruptcy in 1994, for instance, bondholders eventually got all their money back with interest.

Instead, expect to see credit trouble crop up in more obvious places. Land-secured bonds (or "dirt deals")--which finance the public infrastructure costs for new development--fell prey to the same rosy assumptions and lax credit terms characteristic of the real estate bubble. Some projects never broke ground, have been abandoned by developers, and are now burning through rainy day reserve funds. Low occupancy retirement care facilities that require seniors to sell their homes to pay an up-front entrance fee have also been hit hard by falling property values. Another area under stress is industrial development revenue bonds backed by highly levered companies in cyclical industries like airlines, chemicals, and paper. While these rockier sectors are standard fare for high-yield muni funds, most high-quality muni funds have very limited exposure to them, or none at all.

Granted, the worst economy in decades may be enough to undo a few seemingly high-quality muni issuers. That's why, without the fallback of bond insurance, now may not be the best time to test your skill as a bond picker. Meticulous research and good diversification have never been more important traits to look for in a muni mutual fund. We may sound like a broken record when we recommend these shops, but the case for straightforward funds run by the well-supported teams at Fidelity, Franklin, T. Rowe Price, and Vanguard was only strengthened by their strong relative performance in 2008's financial crisis. On the diversification front, the most cautious specialty-state investors (those who get a state tax break for investing in their home state's bonds) might even consider foregoing some of their in-state tax benefits to devote at least a portion of their muni allocation to a national fund.

We wouldn't worry about a well-diversified California muni fund, though. In contrast to states with spotty issuance, munis issued within California's borders comprise roughly 14% of the broader municipal-bond market. Taken together, they make up as diverse an array of bonds--by issuer, sector, quality, and structure--as you'll find anywhere. The state also has a sizable population of wealthy individuals who are natural buyers of tax-exempt bonds. In the hands of a fund manager with the research chops to avoid another Vallejo in the making (a San Francisco suburb that filed for bankruptcy in 2008), you can breathe easier.