Investing in California Municipal Bonds?

Recently, I’ve been taking another look at investing in California municipal bonds. Even if you don’t live in California, the yields can be quite attractive. But is it a good idea?

Tax-Equivalent Yields
Right now, the Vanguard California Intermediate-Term Tax-Exempt Fund (VCAIX) has a yield of 3.49% with an average maturity of 7 years. In addition, since the interest from this fund is exempt from both federal and California state income taxes, the equivalent taxable yield is actually much higher. You can use a tax-equivalent yield calculator to find out how it works out for your tax brackets.

If you are in the 33% federal tax bracket and 9.3% CA bracket, that 3.49% would be the same as a taxable bond yielding 5.74%. Even for an out-of-state investor, the federal tax exemption alone gets you to 5.21%, which is higher than many mortgage interest rates.

If you are in the 25% federal tax bracket and 9.3% CA bracket, that 3.49% would be the same as a taxable bond yielding 5.13%. For an out-of-state investor, the equivalent yield is 4.65%. As you can see, these yields are definitely more attractive for those in higher tax brackets.

Safety Concerns
Is this reckless rate chasing? Let’s look at a few articles on California munis by Vanguard, Schwab, and Fidelity. Here are some highlights:

  • You’re nearly first in line. California’s constitution requires that state general-obligation bond payments take priority over other payments except for those that fund education. This means as a bondholder you’re ahead of other government employees, firefighters, and basically everyone else.
  • Diversify. If you do invest, don’t make it all of your portfolio. There is still some risk. You can still hold other national muni funds, US. Treasury bonds, and investment-grade corporate bonds.
  • Buy a bond fund. I would invest in a managed municipal fund and not in individual securities unless I was very experienced. You don’t want to have to navigate a minefield of call risk, GO bonds, bonds based on sales tax revenue vs. utility fees, and other tricky details.

Holding Period Concerns
It’s important to note the maturity and duration of the bonds you’re buying, because if you have to sell sooner than the average maturity, you’ll be greatly exposed to price volatility. For example, if California’s credit rating drops further, then the current market value of the bonds you buy will also drop. If you sell early, you’ll have to take a loss. However, if you are able to hold a bond until maturity, you’ll still get the fixed yield and the principal back, so it won’t affect you.

Also, if you sell early and the bond value has increased, you may be subject to capital gains taxes from which you are not exempt.

My Personal Opinions
I’ve been keeping track of all the ways the state of California has been trying to manage this budget shortfall, and it is clear they are ready to take some very drastic steps to cut expenses. In any event, I fail to see how the U.S. government would not bail out California if things got really bad. If private corporations can get bailed out, why not a state full of voters? I’m not alone, however, as these bonds have been rallying as of late.

I am thinking of investing in California municipal bonds for a very specific scenario: I would buy them instead of paying down my mortgage further, as the tax-equivalent interest rate from the bonds is actually higher than my (tax-deductible) mortgage interest rate. This way, I both come out ahead in terms of interest and I have good liquidity if I wish to access the money for some reason. I also don’t see myself as taking too much extra risk, as I would with a stock fund for example.

Comments

  1. ParatrooperJJ says:

    Any comments on the proposed constitutional convention wiping out those payback requirements?

  2. 1st in line ? Yeah right – tell that to GM bondholders … Unions are first in line just ask the policymakers who can change the rules anytime they please … No way a firefighter isn’t paid before a bondholder and that includes pension lifetime medical (although soon everyone even the 45% illegals that infest LA) will have that anyway. Heck they already do.

    California is a cesspool that would do America a favor by becoming it’s own socialist country. Nancy Pelosi can be dictator.

  3. I don’t believe you fully appreciate the risks of muni bonds. I wouldn’t rely on a bail-out when the state has the power to raise revenue through legislative action.

    I really don’t want to be rude, but the quality of content has declined here over the past few months. Perhaps like the above article on GO bonds you are reaching a limit in your understanding of investment finance.

  4. I don’t think the California bashing in the comments is really necessary.

  5. My issue is the AMT problem – if you are hit by AMT, your munis are not treated the same as normal. Can you add a discussion of how AMT would impact muni yields?

  6. Paratrooper – Passing a Constitutional amendment that changes the payback requirements would greatly damage the credit rating of CA, hurt their ability to raise future funds, and would further separate them from all the other states. It is a possibility, but it’s a step that would be very close to defaulting, which is really hard to go back from.

    Mike – You’re right, I don’t understand this sentence: “I don’t believe you fully appreciate the risks of muni bonds. I wouldn’t rely on a bail-out when the state has the power to raise revenue through legislative action.”

    So you say there are risks that I don’t appreciate, but you don’t list them? Then you tell me that the state can just raise revenue through legislative action?

    As for post topics, feel free to send me a suggestion, or offer to write a guest post on your own area of expertise.

    jb – AMT is a concern, but that is something I am not very familiar with as I am not (yet?) subject to AMT.

  7. I’m not really aware of the AMT consequences as I have CA GOs and VCAIX unless you mean capital gains. I will agree there is risk but as with every investment. I try to stay diverisfied and keep risks low. I don’t think Ca will default. The CA legislator is being forced to cut costs which is evident now. So, if you are worried about risk, where do you put your money?
    Stocks – We know how that’s been going
    Cash – Can’t live on .1% return
    Tips – Wait for inflation
    Ibonds – 0% for this duration

    I know the end of the world is coming for some but just in case, I will stay invested. (and diversified)

  8. FinanciallyStressed says:

    Don’t let the trolls get to you Jonathan. I appreciate the post!

  9. Rob wrote: “1st in line ? Yeah right – tell that to GM bondholders”

    I was going to say the exact same thing. This is risky rate chasing. Don’t be greedy.

  10. The interest on municipal bonds is only added to AMT if the bond is a “private activity bond”. When they say “private activity” they mean a bond that is used to fund non-government activity. I’m guessing thats stuff like sports stadiums or development projects meant to stimulate the local/state economy.

    The bond information should say if it is subject to AMT. A bond fund should have information saying what (if any) % of the funds dividends are subject to AMT.

    Vanguards funds are here:
    https://advisors.vanguard.com/VGApp/iip/site/advisor/investments/taxcenter/article?file=IWE_VGFundsAMT2008

    The CA funds are at the top of the list and the fund in question has 0% in private activity bonds.

  11. As a Californian, I’m definitely interested in what you have to say about this. Thanks and keep up the discussion!

  12. I don’t necessarily agree with directly comparing a corporate bond like GM with a state general-obligation bond. Corporations go bankrupt all the time. A state has no provisions to declare bankruptcy, and as mentioned has the ability to raise taxes to increase revenue. You can’t just make someone pay $30k for an Impala. Personally, I hope CA takes this opportunity to really trim all the fat out of their budget.

    I do agree that there is some risk, but I’d like to hear some more detailed arguments.

  13. Jonathan:

    I appreciate your post and strongly disagree with anyone complaining about your content.

    I agree that there is risk with CA Muni bonds. As far as bond investing, I leave room for inflation in the next 2-3 years and having money available to take advantage of it.

  14. Let us just think here – in California you pay in taxes on 100k income and owning 800k home (aka renting from bank making them rich):

    $10,000 state tax
    $6,200 FICA tax
    $4,000 Medicare tax
    $20,000 Federal income tax
    $3,000-15,000 in 8%+ sales tax
    $1,000+ in personal property tax

    This in a declining stare where many have lost 100′s of thousands on the house!

    Great state for growth ya got there!

  15. Johnathan: “I don’t understand this sentence: “I don’t believe you fully appreciate the risks of muni bonds. I wouldn’t rely on a bail-out when the state has the power to raise revenue through legislative action.””

    Perhaps I should have said: The reason california will not get a federal bail out is that the government of california has the ability to raise revenue. However, the last political budget crisis clearly enumerated that the government and people of california do not have the political will to raise taxes. Thus default risk. GO bonds are subordinate only to the education system, meaning bond payments come before the prison system – what is the likelihood that California decides to release prisoners in order to make a debt payment. Will next years budget battle be even worst? We just went through a period where CA was printing their own currency …

    So in your case the VG fund is at 5.74 and your after tax mortgage rate is ~4%?? The different in rates would be known is ‘the risk premium’. To me, not worth it, but you’re free to make your own investment decisions.

  16. Forgot to add in property taxes! what’s 1.5%*800K oh another $12,000

    so lets see

    $12,000+$10,000+$6,200+$4,000+$20,000+$8,000+$1,000 in various taxes = $61,200!

    Enjoy what’s left LOL Repairing a deck?

  17. Rob – I get it. You don’t like the idea of living in California. Can you accept that others do, despite the higher taxes vs. some other states? Your repeated comments in every post of mine mentioning California are getting a bit tedious.

  18. Jon,

    As an example, if I invest in VCAIX now, in seven years will it mature giving me back the principal+interest?

    Is the interest given to me every month or year, or in a lump sum at the end of seven years? I went through the Vanguard information on VCAIX but I couldn’t find the answers to these.

  19. FinanciallyStressed says:

    My understanding is that bond funds (unlike bonds) never really “mature” – so your principal is always at risk if the NAV goes down, even if there is no default, because you can’t hold the bond fund to “maturity.” It would be great if someone else could chime in and add to/correct my limited understanding.

  20. I just bought 3k (the minimum) of VCAIX. Hopefully it’ll do well.

  21. I am new to bond funds. I have a newbie question. I love the interest rate with bond funds, but wouldn’t the price fluctuates too? If the demand for it become low and price drop, we would still lose money after interest right? Is buying the bonds directly from gov the only way to get the interest for sure? But then, that would lock your money in for 7 years right?

  22. I think muni bonds are a great investment, especially in high tax states such as California. I think they are especially valuable for single filers and/or renters who have few other options to reduce tax liability. Although they are more volatile you may want to look at some muni ETFs and CEFs. A couple which I have invested are AFB, MUS, PCQ, TFI. The big problem withe ETFs and CEFs are they are far more volatile so I would suggest diversifying with 50 state munis and/or insured munis. Some also employ leverage to increase returns so look closely at the funds.

    I think default risk is not the big problem, but if inflation becomes a problem the value of the funds will get hit and perhaps more than offset any income you have accumulated. Overall I think they are a great part of any portfolio, I have about 35% of my portfolio in munis but t

  23. Jon,

    I am currently swimming the California cesspool (kidding, love it here) but I am originally from the east coast. I love the idea of investing in municipal bonds as a way to help out your city/state/region but I am wondering how this works with out-of-state purchases and transfers. For instance, are there any penalties if I buy into a CA muni fund now and move back to the east coast in a year or two?

    Thanks and keep up the good work!

  24. @Rich,

    States vary on how they handle other state MUNIs. Basically, they are all Federal tax free but you may have a tax liability at the state level. For diveristy, I have a position in Vanguard VWITX and CA does tax some of the interest. I am also swimming in the California cesspool. (yes, I like here too)

  25. Here is a good link on individual bonds vs. bond funds.

    http://www.bogleheads.org/wiki....._Bond_Fund

  26. @FinanciallyStressed: You are absolutely right. There are important differences between individual bonds and bond funds that go beyond diversification or lack of knowledge. It is not as simple a decision as Jonathan says as these are simply different investments.

    When you buy an individual municipal bond – you buy an IOU which operates like an interest-only loan: you get simple interest that gets paid to you as income twice a year plus a promise to pay you the face value of the bond at maturity. Between today and the maturity date, the resale value of your bond may fluctuate, and you may resell it if it goes sufficiently high that it no longer makes sense for you to hold on to it. It may go down in value as well – based on risk perception, change in credit rating or an increase in interest rates. But unless the issuer defaults, you always have an option to hold to maturity and get the face value of the bond back and interest payments until then. You also know credit rating of your bond – and obviously the lower the credit rating the higher rate you can get.

    Additionally, you can buy an individual municipal bond at a discount (below par), for the face value (at par) or at a premium (above par). I.e. if the bond’s face value is $5000 (it’s usually $1000, but they normally sell in lots of 5), you can buy for below or above this value. The value depends on current interest rates vs bond’s rate as well as risk perception. For example, last fall, the risk was perceived to be high so you could’ve bought AAA municipal bonds with a rate of 5% at a discount. I.e. instead of paying $5000, you would’ve paid $4500 for some bonds. Right now, most of these bonds are selling at a premium, so you’d need to pay over $5000 for $5000 worth of bonds. But the interest rate is still calculated based on $5000, so your interest payments would still be $125 every 6 months, and at maturity, you still get $5000. The number to look for when you compare individual bonds is yield-to-maturity (YTM) which is calculated based on all of these factors – rate, purchase price, maturity date and the amount you get at maturity. GO bonds are considered safer than revenue bonds. In terms of taxes, only the interest payments are tax free. The difference between your purchase value and what you get is treated the same way as capital gain or loss (to the best of my knowledge).

    The major drawback of individual bonds for many small investors is that they simply don’t have enough money to buy multiple bonds to diversify. Usually, you need to spend at least $5000 (less if you are below par, more if tiy are buying above par) on a single issue. Which means that you need a nice chunk of money to diversify. Now, at present I only have a few issues of municipal and corporate bonds, but a) I bought the bonds last fall and earlier this year – all with high credit rating – when the yields were very attractive, so for me the yields I got justified the risk of not being diversified. I also bought high quality issues. b) I have money to increase my holdings when I find the yields are attractive c) what I currently have invested in these individual bonds is a fairly small percentage of my holdings and I can afford to lose it. But in general, you really need to have money.

    Another drawback of individual bonds is that the interest is not compounded. Now, if you have 100K in bonds, than you may get enough in interest to buy another issue. But if you have less, you need to decide what to do with the money.

    The advantage of bond funds is that you get diversification and compound interest and you don’t need a lot of money to invest. The disadvantage is that you no longer have the option of waiting to maturity so your principal is not protected. If at the time you take the money out of the fund, the bonds’ value is below your purchase price, you may lose money. This may happen even without default: e.g. with California bonds, the buyers may perceive higher risk or with all bonds – the interest rates may go up.

    So you see – there are advantages and disadvantages of bonds and bond funds.

  27. I was wondering for funds like VCAIX, would it be best to buy it in a 401K, a roth IRA, or a taxable account? My guess is the taxable account as the other two would not give me the benefits of purchasing such a fund.

  28. Usually when stock goes up. bond goes the other way, these days both are up each day, I don’t feel this is normal, any analysis on why CA muni are up these days given the fact that the state is still in financial trouble and potential interest rate going up?

  29. Excellent article in today’s WSJ on this.
    http://online.wsj.com/article/.....nalfinance

    Bottom line, bond prices will go down as the interest rates (fed funds rate) goes up.

    Best to stick with short-term funds if you’re going that route

  30. Christopher says:

    Given the treatment of bond holders in the Chrysler and GM government bailouts, a.k.a. bankruptcies, I would be somewhat apprehensive of predicting how the federal government treatment would treat all the players in a California bankruptcy.

  31. This is probably a dumb question but what are the reasons for investing in VCAIX instead of VCITX, the long term equivalent? Also I noticed VBIIX, the taxable equivalent, is outperforming, maybe more than the tax difference if you’re in the 25% tax bracket.
    Would appreciate your advice and thanks for the blog.

  32. A long-term bond fund is more sensitive to interest rates, and thus will be more volatile. This post should be helpful:

    http://www.mymoneyblog.com/arc.....ation.html

  33. William Oppenheim says:

    No State has ever gone bankrupt. California is releasing prisoners, cuting services, trimming University and Educational budgets, and they will raise taxes as will the Feds. The combination of raising taxes will make these bonds even morevaluable, and to some extent will blunt the inflation that is certain to occur when it comes to the actual price of the bnds on the open market. But who really cares about these bonds on the open market. These are investments you hold to maturity; bond traders are a breed apart and will tear you apart if you even think of making thee things short terms investments. Buy them for the income, and don’t even look at the value prior to maturity. Just enjoy the tax free / AMt free income while everyone else complains about the rising taxes.

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