Perhaps no area in the U.S. (with the possible exception of Michigan) has felt the pinch of the recession worse than the Golden State. California, the most populous state (home to eight of the country’s 50 largest cities) and third-largest by land area, has seen tax revenues plummet and unemployment skyrocket over the past 18 months, pushing the state to the brink of default. As California has fallen on hard times, many investors are taking a close look at ETFs that invest in municipal bonds issued by California agencies, attempting to track down an answer to the the million dollar question: are California Munis now a good value play, or simply a sucker’s bet?
California’s fall from grace has been a steep one. The state that was once home to the world’s seventh largest GDP has been reduced to issuing IOUs to vendors whom it doesn’t have the funds to pay. The once strong credit rating has collapsed. The state is regularly rated as having the worst business climate in the country. Taxes are through the roof, with no prospect for relief in sight. You get the point – this list could go on and on. After months of haggling, legislators appear to have finally agreed on a budget to close the nearly $26 billion gap. The “final” version will cut $15 billion from state services, but discarded plans to take away gasoline tax revenues from local governments and scrapped a plan to drill for oil off the coast of Santa Barbara, according to the New York Times. There are numerous opinions as to the culprits to blame for the demise of the California economy, and the list of victims is equally long.
While it seems unlikely that the state will go bankrupt, investors are clearly concerned about California’s willingness and ability to repay its debts. California municipal bond ETFs track benchmarks that are comprised primarily of bonds guaranteed by the state’s general obligation fund. According to Murray Coleman at Index Universe, California Treasurer Bill Lockyer has declared that only “thermonuclear war” could derail payments of such bonds. A few of the ETFs offering exposure to California municipal bonds:
- iShares S&P California Muni Bond Fund (CMF): CMF has had its share of ups and downs so far in 2009, but is close to break-even on the year. This ETF recently had a 30-day SEC yield of 3.89%, implying a taxable equivalent of about 6%.
- SPDR Lehman California Municipal Bond ETF (CXA): This ETF tracks a rules-based index that invests in California municipal bonds rated AA- or higher. CXA recently had a 30 day SEC yield of 4.37%
- PowerShares Insured California Municipal Bond Portfolio (PWZ): Based on the Merrill Lynch California Insured Long-Term Core Plus Municipal Securities Index, PWZ holds AAA-rated (although currently more than 50% of its holdings are rates AA or less), insured, tax-exempt, long-term debt publicly issued by California, Puerto Rico, or their political subdivisions. PWZ has dropped a bit from recent highs, but is still up more than 4% on the year, significantly ahead of CMF and CXA. PWZ recently had a 30-day SEC yield of 4.92%.
California Munis are currently offering very attractive returns relative to more diversified bond ETFs (AGG recently had a 30-day SEC yield of 2.18%), particularly considering that income from these investments isn’t subject to the same taxation that eats into corporate bond returns. But, to be sure, there is commensurate risk. While Lockyer’s guarantee is reassuring, the reality of the situation is rather depressing:
- The state’s debt is currently rated BBB, just two grades above junk bond territory
- California issued more than $31 billion of debt for the six months ended June 30
- On July 2, California began issuing IOUs in lieu of payments to taxpayers owed refunds and to vendors owed for services rendered in an effort to preserve dwindling cash reserves
- Home prices have plummeted in LA (down 19.8% over the last year), San Diego (down 18.5%), and San Francisco (down 26.1%)
- Unemployment stands at 11.6%, up from 7.1% a year earlier, and jobless rates are not expected to retreat to single digits until late 2011
Bonds are ideal for investors looking for a steady return to reduce the volatility of equity investments. But given all of the uncertainty surrounding California at present (the Wall Street Journal recently called the state “ungovernable”), investors can’t necessarily expect a smooth ride in any of these ETFs. Those willing to ride out the storm (I doubt the latest version of the budget will put to bed all credit fears) may generate some handsome returns, particularly those in high tax brackets. But they also run the risk of ending up with a worthless IOU if the state experiences a prolonged recession.
Disclosure: No positions at time of writing.