Your Muni’s Worth

When the topic turns to California municipal bonds, the voice of Zane Mann is one that many investors trust. Mann’s California Municipal Bond Advisor newsletter, which he’s been publishing monthly since 1983, is one of the few independent sources of information on California munis that is readily available to individual as well as professional investors. With his plain-spoken but lively writing style, Mann comes across as something of a Will Rogers of municipal bonds, attempting to shed light on a sometimes arcane world in which timely information is often hard to come by.

Mann, who is 74, has had a professional interest in munis since 1953, when he teamed with a lawyer friend in forming a bond-underwriting firm in his native Minneapolis. At that time, relatively few cities or counties issued bonds to build water systems, irrigation networks, schools and the like, so Mann flew around the Midwest in small planes searching for towns that seemed to be in need of public works and the means to finance them. Over the next couple of decades, he also served as a muni bond trader, as a financial consultant to municipalities and in related roles until 1972, when he embarked on what turned out to be eight years of sailing around the West Indies and the Mediterranean. He wrote a book, “Fair Winds and Far Places,” describing those experiences.

Mann attended the University of Minnesota before enlisting in the military during World War II, when he served as a combat newsreel correspondent. Today, Mann, who has lived in Palm Springs since the early ‘80s, spends much of his time volunteering at the Palm Springs Air Museum, which features a collection of vintage military aircraft and dozens of his war photos. Mann spoke recently with Russ Wiles, a mutual funds columnist for The Times.

Times: How have municipal bonds been doing lately?

Mann: Interest rates have been creeping down since April, and when interest rates go down, [bond] prices go up. One interesting thing is that there was a net outflow of money from California municipal bond funds in 1995 and 1996, led by very conservative, older investors who decided they needed to get in on the stock market boom. Over the last month or so, people seem to have grown more concerned about a possible stock market crash, so the inflow of cash into California municipal funds has increased. I suspect that many conservative investors are frightened and are heading back into tax-exempt bonds.

Times: What sort of yields are California munis now paying?

Mann: Yields are down to 5.5% to 5.8% on the long end, for bonds with 25- to 30-year maturities.

Times: Do you attempt to forecast the direction of interest rates?

Mann: No. I’m not looking to earn a capital gain. For most muni bond investors, the goal simply should be to earn a good, steady stream of tax-exempt interest. The fact that a bond fund, for example, is up 10 or 15 cents a share doesn’t mean anything, because you’re probably not going to sell it anyway.

Times: But you prefer certain types of bonds in terms of credit quality? Many investors prefer to buy safer bonds.

Mann: Yes. In California, about 62% of all new bonds these days are insured, which means they are rated AAA, the top grade. At the other end, about 10% of the bonds are junk issues, including the so-called [real property-backed] Mello-Roos bonds which are so bad they should not even be sold. What’s left are the investment-grade bonds with ratings of BBB or better. Maybe 15% of the market represents such bonds from recognizable issuers. So, really, there’s not a lot of choice aside from insured bonds, especially when you consider that the muni bond funds buy most of the long-term bonds anyway.

Times: Do you favor bonds with maturities in a certain range?

Mann: Bonds in the 15- to 20-year range seem to offer the best yields for the risk.

That said, muni bond yields move with general interest rates. It’s very rare when something gets out of line--the state of California’s general-obligation bonds would be one of the few exceptions currently. But for the most part, everything moves in lock-step. You just have to buy when you have the money.

Times: The Orange County debacle has raised investors’ concern about defaults. Are the consortiums that issue bond insurance strong enough to handle future defaults?

Mann: Yes. They almost never face a loss, and when they do sustain a loss, they move quickly to settle the situation, like taking over a city until they straighten things out. It’s a great business, taking in billions of dollars in premiums and almost never facing a claim.

Times: Could you name a couple of favorite bond issues?

Mann: First, I’d recommend the state of California’s general-obligation bonds. Huge amounts of state GOs come to market every year, and they’re currently good buys, because I think the state’s credit rating shortly will be upgraded.

Also, I think bonds issued by many of the big municipal utilities are attractive. Even though utilities are facing deregulation, I’m not frightened by it. These are revenue bonds, meaning investors are repaid with money generated from utility operations. Revenue bonds are a bit riskier but offer slightly better yields than general-obligation bonds, which are backed by the full taxing power of the issuer, such as the state of California.

Times: Which municipal utilities do you like?

Mann: One favorite is the Los Angeles Department of Water and Power. Others include the Southern California Public Power Authority [a financing organization for 11 consumer-owned power districts], the Metropolitan Water District, Northern California Public Power and the Sacramento Municipal Utility District.

Times: Do all of these utilities have bond issues in that 10- to 20-year maturity range?

Mann: Yes.

Times: What’s wrong with Mello-Roos bonds?

Mann: These are bonds backed specifically by real estate. [It’s also rare that they are rated, and there’s no secondary obligation on the part of the issuer.]

We’ve gone through a depression in real estate since 1990, and the value of the land that secured some of these bonds has dropped below the value of the debt. For bondholders, the only recourse is to foreclose on the property and hold a courthouse sale, yet they often can’t get bids on the land. Mello-Roos bonds have been issued since 1983, but the average investor would be wise to avoid them.

Times: Do you see much danger of another big default like the one that hit Orange County in late 1995?

Mann: No. A few small communities have got stuck in terrible financial difficulty, like Arvin [in the San Joaquin Valley] or the Richmond School District [in the San Francisco Bay Area] several years ago. And there are others, like Wasco [in the Central Valley], that have taken on enormous debts to build nonessential things like golf courses that have not worked out well. But these are bonds the average investor should not have bought in the first place. In general, defaults are not a serious problem.

Times: Do you think people should buy individual bonds or invest through one of the many California muni bond mutual funds?

Mann: It’s really a matter of investable funds. If you have less than $100,000, buy a mutual fund. If you have $100,000 or more, then you can begin to put together your own portfolio, investing $25,000 or so into four or more separate issues. So you might buy $25,000 worth of Cal GOs, $25,000 in Met Water bonds and so on.

Times: If each muni carries a face value of $5,000, why do you recommend buying in blocks of $25,000 or more?

Mann: To get better prices. Bond traders don’t like to deal in small quantities, so they won’t give you a decent price for them.

Trading costs are a reason that bond buyers typically hold to maturity. They do very little trading.

[But] even investors with a lot of money might prefer a fund, especially since there’s [often] no sales charge if you buy $1 million worth of a load fund.

Some of my subscribers have invested more than $1 million in the Franklin California Tax-Free Income Fund, for example. Mutual funds offer greater convenience, since it’s the portfolio manager who has to worry about reinvesting interest payments and the like. Also, people owning individual bonds have had a number of them called or advance-refunded in recent years, which means they had to roll over their money into new bonds. That can be a pain, especially since they have not enjoyed as good a selection of new bonds as in the past.

Times: Any favorites among the California muni bond funds?

Mann: I like the big firms because they employ large staffs of analysts who keep track of bonds. The largest players really dominate the industry. For example, Franklin California Tax-Free Income counts $14 billion in assets, while the Franklin California Insured Tax-Free Income Fund, which was started only a few years ago, is now the third-largest in the state.

Times: How about a choice for a smaller investor who doesn’t want to pay a sales charge on a mutual fund?

Mann: I like the California bond funds offered by the American Century-Benham group, especially the intermediate and long-term portfolios.

Times: You mentioned earlier that you don’t pay much attention to capital gains. Why not?

Mann: Morningstar, the L.A. Times, Forbes--everybody ranks mutual funds by total return, which includes capital gains or losses in addition to yields.

For stock funds, that’s completely understandable. But it doesn’t make sense to rank a tax-exempt fund using its total return. Here’s why: Assume you pay $10 a share for a tax-exempt fund and assume, to make it easy, that it pays 10% interest. The day after you buy it, interest rates shoot up, so the share price of your fund goes down. Because interest rates rose, your current yield will go up, as the portfolio manager buys higher-yielding bonds with the dividends that you and other shareholders reinvest. So instead of getting $1 a share each year, you might receive $1.25 or $1.50. If you reinvest your dividends--a key reason to buy a bond fund--you essentially are taking a higher dividend and reinvesting in a lower share price. So you obtain more shares than would be the case if the fund’s price stayed flat or appreciated.

Further suppose that after 10 years, interest rates fall, the price rises back to $10 and you sell. Even though you may have lived with a negative total return for most of those 10 years, you would have finished with a high, positive return at the end. What made this possible was dividend reinvestment.

Times: Do you ever recommend national muni bond funds or out-of-state issues for California investors?

Mann: No. If you’re a resident of California and you’re in the maximum state income tax bracket, you pay 9.3% in taxes on the income from an out-of-state bond. Admittedly, you can deduct that for federal tax purposes, so it nets out to be 6.7%. But you still would have to find an out-of-state bond of equal quality that yields nearly half a percentage point more in order to come out ahead with what you can get from California bonds on an after-tax basis. Yet it’s hard to find [such] bonds.

Times: Has the attractiveness of muni bonds and bond funds been affected by this year’s tax-reform legislation?

Mann: The recent law really doesn’t affect them. The debate on flat taxes did frighten the market, but that was two years ago.

Times: Obviously, California munis are suitable for upper-income people. But at what tax rate do they make less sense?

Mann: I wouldn’t consider them for anyone in the 15% bracket. But the 28% bracket starts at just $42,351 in joint income and $25,351 in income for single people. Also, almost everybody in the 28% federal bracket pays a top marginal state rate of 9.3%. [See accompanying chart.]

Times: Though the bonds are all from one state, is the California market sufficiently big and varied enough to offer a spreading of the risks of default or delayed payments?

Mann: I sat down two or three years ago to guesstimate the amount of California bonds outstanding at the time and came up with a figure of $130 billion.

That’s a big market, with further diversification provided by the state’s large geographic area and broad mix of industries.

Frequently I am pulled into this debate with Eastern writers or analysts who think California is going to fall apart because of earthquakes or whatever. They tell me it’s not wise to invest in a single state because there’s not enough diversity. In response, I like to note that the state of California is geographically larger than the six New England states plus New York state. The populations are about the same, and personal income is about the same. But economic diversification is greater in California than it is in those seven states combined.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Profile: Zane Mann

Position: Publisher of the monthly newsletter California Municipal Bond Advisor ($125 a year; [760] 320-7997), which contains news and analyses of developments and trends in the California tax-free bond market.

Background: Minneapolis-based bond underwriter, trader and financial consultant to municipalities from 1953 to 1972; SEC registered investment advisor, certified financial planner and member of the California Society of Municipal Analysts.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Muni Bonds: True Yields

The yield on a California municipal bond or bond fund is effectively higher for anyone who pays state and federal taxes. The higher your tax rate, the higher the taxable yield you would need to end up with as much money as a tax-free yield gives you. Equivalent yields at various tax rates:

*

Adjusted gross income tax brackets

- Joint income: $42,351 to $52,090

- Single income: --

Federal and state tax rates: 28+6%

Combine effective rate: 32.3%

A current California tax-free yield of 3% is equivalent to a taxable yield of: 4.43

A current California tax-free yield of 4% is equivalent to a taxable yield of: 5.91

A current California tax-free yield of 5% is equivalent to a taxable yield of: 7.39

A current California tax-free yield of 6% is equivalent to a taxable yield of: 8.86

A current California tax-free yield of 7% is equivalent to a taxable yield of: 10.34

*

Adjusted gross income tax brackets

- Joint income: 52,091 to 85,832

- Single income: 25,351 to 32,916

Federal and state tax rates: 28+8

Combine effective rate: 33.8

A current California tax-free yield of 3% is equivalent to a taxable yield of: 4.53

A current California tax-free yield of 4% is equivalent to a taxable yield of: 6.04

A current California tax-free yield of 5% is equivalent to a taxable yield of: 7.55

A current California tax-free yield of 6% is equivalent to a taxable yield of: 9.06

A current California tax-free yield of 7% is equivalent to a taxable yield of: 10.57

*

Adjusted gross income tax brackets

- Joint income: 85,833 to 102,300

- Single income: 32,917 to 61,400

Federal and state tax rates: 28+9.3

Combine effective rate: 34.7

A current California tax-free yield of 3% is equivalent to a taxable yield of: 4.59

A current California tax-free yield of 4% is equivalent to a taxable yield of: 6.13

A current California tax-free yield of 5% is equivalent to a taxable yield of: 7.66

A current California tax-free yield of 6% is equivalent to a taxable yield of: 9.19

A current California tax-free yield of 7% is equivalent to a taxable yield of: 10.72

*

Adjusted gross income tax brackets

- Joint income: 102,301 to 155,950

- Single income: 61,401 to 128,100

Federal and state tax rates: 31+9.3

Combine effective rate: 37.4

A current California tax-free yield of 3% is equivalent to a taxable yield of: 4.79

A current California tax-free yield of 4% is equivalent to a taxable yield of: 6.39

A current California tax-free yield of 5% is equivalent to a taxable yield of: 7.99

A current California tax-free yield of 6% is equivalent to a taxable yield of: 9.59

A current California tax-free yield of 7% is equivalent to a taxable yield of: 11.19

*

Adjusted gross income tax brackets

- Joint income: 155,951 to 278,450

- Single income: 128,101 to 278,450

Federal and state tax rates: 36+9.3

Combine effective rate: 42.0

A current California tax-free yield of 3% is equivalent to a taxable yield of: 5.17

A current California tax-free yield of 4% is equivalent to a taxable yield of: 6.90

A current California tax-free yield of 5% is equivalent to a taxable yield of: 8.62

A current California tax-free yield of 6% is equivalent to a taxable yield of: 10.37

A current California tax-free yield of 7% is equivalent to a taxable yield of: 12.07

*

Adjusted gross income tax brackets

- Joint income: More than 278,450

- Single income: More than 278,450

Federal and state tax rates: 39.6+9.3

Combine effective rate: 45.2

A current California tax-free yield of 3% is equivalent to a taxable yield of: 5.47

A current California tax-free yield of 4% is equivalent to a taxable yield of: 7.30

A current California tax-free yield of 5% is equivalent to a taxable yield of: 9.13

A current California tax-free yield of 6% is equivalent to a taxable yield of: 10.95

A current California tax-free yield of 7% is equivalent to a taxable yield of: 12.87

*

Source: Zane Mann, California Municipal Bond Advisor