Bonds . . . Muni Bonds

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.

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.

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Times: But you prefer certain types of bonds in terms of credit quality?

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.

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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.

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Times: 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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.]

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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.

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Zane Mann will appear at the Times Investment Strategies Conference panel on California muni bonds at 2:45 p.m. Sunday.