How Safe Are Different Types of Muni Bonds?

“How safe are my muni bonds?”

A growing number of California investors are asking that question, as the state and many of its cities, counties and school districts wrestle with unprecedented budget deficits.

Though the vast majority of California muni bonds remain problem-free, state agencies, brokerages and bond rating firms are scrambling to gather fresh information on this often-murky $130-billion market and its myriad issuers.

The high level of concern stems from the feeling that the Golden State has never before faced the current confluence of events: A grave fiscal crisis coinciding with an eroding business tax base, after a long period of record borrowing to build roads, schools, hospitals, sewers and other public works.

More worrisome is that much of the borrowing by California municipalities over the past decade has been designed to circumvent the tax limitations imposed by Proposition 13 in 1978.

Now, the wisdom and legitimacy of some of the debt end-runs--including the wildly popular “Certificates of Participation” and the so-called Mello-Roos real estate bonds--are being challenged as issuers find their budgets severely squeezed.

The great fear is not that a mass of bond defaults is looming in California, but rather that enough defaults could occur to dramatically alter investors’ confidence in the muni market.

Indeed, for most individual investors, the details of how muni bonds work has until this year seemed of little importance. Convinced of the bonds’ inherent safety, investors have focused almost exclusively on the yield they’d earn and its double tax-exemption: Interest paid on California muni bonds is free of both state and federal income tax, a lure that gives munis a marketing advantage over virtually any other form of fixed-income investment, from bank CDs to U.S. Treasury bonds.

The question now is whether the high returns on some California munis should have been a warning sign that disaster was inevitable.

What follows is a look at the four main categories of muni bonds in California, how each is expected to fare as the state’s recession wears on, and what individual holders of each type of bond should be asking:

General Obligation Bonds: A “G.O.” bond is backed by the issuer’s full faith and credit. That usually means that the issuer has the power to raise taxes on its constituents if necessary to make sure bondholders get paid what they’re owed.

For that reason, “G.O.s typically are the most secure muni bonds,” says Steven Zimmerman, analyst with the bond-rating firm Standard & Poor’s Corp. in San Francisco.

Most G.O.s in California are issued either by the state or its largest cities and counties. They pay for public projects approved by voters, such as new schools or prisons.

While investors who own G.O.s have no real worries about default, the resale value of the bonds can be affected by Wall Street’s perception of the long-term health of the borrower.

California, for example, fell from a sterling “AAA” credit rating earlier this year to “AA” as the state budget deficit ballooned with the recession. That has kept yields high on the state’s G.O. bonds--around 6.5% annualized for 20-year issues--while less-troubled states have seen their bond yields ratchet lower.

Now Standard & Poor’s and other major rating services are threatening to downgrade California again as Gov. Pete Wilson and the Legislature wrestle with a $6-billion budget deficit.

Another downgrade could force the state to pay higher yields on new G.O. debt, thereby depressing the resale value of older bonds.

That would only matter, however, to bond owners who might need to sell the bonds before they mature. If you don’t have to sell, a G.O. ratings downgrade needn’t worry you: You can ride it out, assured that your interest payments will keep coming.

Revenue Bonds: These bonds are sold to finance specific projects. The taxes, user fees and other revenue collected on the projects are used to pay interest on the bonds and return bondholders’ principal when the securities mature.

Thus, revenue bonds are only as strong as the projects behind them. For the most part, analysts consider revenue bonds in California to be of high quality--especially in the case of “essential” projects, such as those funded by the Los Angeles Department of Water and Power.

“L.A. DWPs are as good a bond as you could ever ask for,” says Zane Mann, publisher of the California Municipal Bond Advisor newsletter in Palm Springs.

That doesn’t mean, though, that revenue-bond owners can ignore the state’s budget problems. As state funding is cut across the board, virtually all public agencies will suffer in kind. To meet their own budgets--including interest on their bonds--many water, power and health care agencies will be forced to raise user fees, cut services, or both.

The potential budget fallout on hospital revenue bonds in California is of greatest concern to analysts today, because the health care sector in general is under severe financial pressure.

“You have to watch hospitals carefully, because they can deteriorate quickly,” warns Bernie Schroer, manager of the $12.6-billion Franklin California Tax-Exempt bond fund.

If you own revenue bonds, analysts suggest doing some basic research on the health of the issuer. How much leeway does the issuer have to raise taxes or fees to cover cuts in state or local funding?

Certificates of Participation: “COPs” have been heavily issued by municipalities across the state in recent years as substitutes for bonds. They are among the least understood munis--yet potentially are the securities most at risk in the current budget crunch.

COPs, used to fund all kinds of local public works, were designed to get around the tax- and bond-issuance limitations imposed by Proposition 13. While a bond requires a pledge of new tax money to fund interest payments if necessary, a COP doesn’t. Instead, interest payments on COPs can come solely from the issuer’s annual budget, and thus are effectively at the issuer’s discretion .

In practice, COPs have worked out fine, because most city, county and school district officials understand the importance of paying their debts. But as budget problems worsen dramatically, the state is concerned about how COP securities will be treated, especially by the smaller municipalities and school districts that have used them.

This week, the watchdog California Debt Advisory Commission will hold public hearings on the status of COP debt. “We’ll be looking at the ability and willingness of issuers to pay these debts,” says Stephen Shea, CDAC’s director of policy research.

Concern about COPs has mushroomed in recent months, following the Richmond Unified School District’s default on $9.8 million of its COPs. The state has insisted that it won’t bail out Richmond’s COP debt, for obvious reasons: Sacramento doesn’t want to send a message that strapped school districts can simply lay their debt problems at the state’s door.

Richmond is a special case, analysts agree, because the district issued COPs not to fund a new public works project but rather to mortgage existing buildings; the money raised was then used in part to fund the district’s budget deficit.

If you own a COP, analysts advise rechecking what your money was used to fund. The more essential the project--say, a new city hall building or a new high school--the less likely it is that the issuer would try to walk away from the debt.

If the project was a “luxury,” such as a municipal golf course, however, you should look much more closely at the issuer’s willingness to pay, analysts warn.

Mello-Roos Bonds: These securities have had more negative publicity than perhaps any other muni bond. Yet as Zane Mann notes, there are only $3.5 billion worth of Mello-Roos bonds outstanding, while California municipalities have pumped out more than $20 billion in COPs in recent years.

Like COPs, Mello-Roos bonds have been used to get around Proposition 13 tax limitations. Cities and other jurisdictions allow real estate developers to issue the bonds bearing the jurisdiction’s name. The money typically is used to install roads, sewers and other amenities in a future housing development. When the homes are built, taxes paid by the new residents go to pay interest and principal on the bonds.

But until then, the developer alone is responsible for payments on the bonds--not the city.

The fear now is that some developers who funded sites with Mello-Roos money in recent years have been unable to sell homes on those sites, as the California real estate market has cracked. If the developer then runs out of cash, there’s potentially no one to repay the bondholders.

Mann points out that a Temecula Mello-Roos issue is the only known default so far. But he admits that the crunch in Mello-Roos problems--if there is to be one--is likely to occur during the next 12 months or so.

That’s because many of the bonds issued in 1990 and 1991 “capitalized” some interest. That is, money from the offering was set aside to pay the first two years’ interest. Only after those funds run out does the developer face trouble if no homes were built.

If you own Mello-Roos bonds, analysts say it’s crucial that you know the financial health of the developer who stands behind the bonds, and whether in fact the site you helped fund has been developed. The governing board of the jurisdiction whose name is on the bonds should be able to give you that information.

The California Debt Explosion State and Local Borrowing Soars . . .

Annual note and bond issuance by California and its municipalities, including cities, counties and school districts, has doubled since 1987.

(In billions of dollars):

1987: $17.38

1988: 22.49

1989: 22.36

1990: 24.13

1991: 34.82

. . .and More Local Debt is in “COPs”

Many California municipalities, unable to issue bonds because of Proposition 13, have increasingly sold investors Certificates of Participation--or COPs--considered much riskier than bonds.

COP issuance by California municipalities in 1991: $5.17 billion Source: California Debt Advisory Commission