Playing It Too Safe

Less risk, please. That’s what California residents who like the tax advantages of municipal bonds are asking for these days.

Many want their California tax-free bonds to come wrapped with the security blanket of bond insurance, even though that extra safety means earning lower yields.

Such insurance, provided by a handful of private financial firms well-known on Wall Street, guarantees that a bond will be paid back with full principal and interest even if the city, county, school or state that issued it goes bust.

Insurance makes good sense when you’re buying individual muni bonds. But should California investors who invest in munis via mutual funds choose funds that buy only insured bonds?

Some analysts say no. “To invest in an insured municipal fund is either an exercise in laziness or total ignorance,” contends Richard Lehmann, president of the Bond Investors Assn. in Miami Lakes, Fla., which focuses on issues important to individual bond owners.

The primary argument against insured funds is that the risk of loss from defaults within a fund isn’t high enough to justify the lower yield that insured funds typically pay versus uninsured funds.

Indeed, the chance of default, and of actually losing money from a default, are low in the muni bond sector anyway.

Despite some high-profile problems in recent years, California municipal bonds remain one of the safest investments around. Orange County is out of bankruptcy and its bond investors who held on didn’t lose any money. The state’s economy is looking better. California’s general-obligation bond rating just got an upgrade this spring after declining for years.

Second, with a mutual fund you have a diversified portfolio of many bonds. So a default in any single issue is likely to be cushioned by the other issues.

Defaults are even less of a concern in the largest, most diversified funds packed with bonds from all parts of California, such as the massive $13.4-billion Franklin California Tax-Free Fund.

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Even when a muni default occurs, most are worked out so that investors get at least part of their principal back. Unlike a private firm that can disappear, a city or county isn’t going anywhere and will need investors’ goodwill in the future to borrow again.

When Orange County was in bankruptcy it never actually defaulted on the bulk of its bonds, and it continued making principal and interest payments to investors. In the end, the county’s bond investors were paid principal and interest in full, and some were even paid extra interest for agreeing to wait a year for repayment of their bonds.

Still, many muni bond investors worry. Investing in a muni fund that buys only insured bonds has been likened to wearing both a belt and suspenders to keep your pants on, but they are what many fund investors want.

Assets in insured California muni bond funds have grown to $3.7 billion now from $1.9 billion in 1991, a nearly 50% increase, according to Lipper Analytical Services. During the same period, assets in insured muni bond funds nationwide rose only 20%.

Because so many California municipalities are using insurance to enhance the appeal of their bonds, there’s no shortage of insured issues for insured-only funds to buy. In the first nine months of this year issuance of insured California bonds increased 56% over the same period of 1995. That’s been a big boon to once-sleepy funds like the Franklin California Insured Tax-Free Fund, which has grown to become the third-largest of all California muni funds, at $1.6 billion.

Most folks attracted to tax-exempt bonds are conservative investors who like safety, safety and more safety. And California muni fund investors, in particular, may argue that they have good reason to seek an extra margin of safety with insurance.

They may note that muni bonds in California are some of the nation’s most complex. There are earthquakes here, after all. And lately, the Securities and Exchange Commission has been probing muni deals for improprieties that could jeopardize their tax-free status.

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But all insured bond or insured bond-fund owners are giving up some yield for the safety of insurance. How much yield? In the case of the funds, Lipper Analytical says the average 12-month yield on California insured funds was 4.74% as of Sept. 30. Owners of non-insured funds were getting a yield of 5.09% on average.

Lehmann’s argument is that it isn’t worth sacrificing that difference in yield. Just own a non-insured fund, he says.

Yet in terms of total return--measuring the yield and the change in principal value over time--insured funds actually have beaten non-insured funds over the past five and 10 years, on average.

Lipper says the average total return on California insured funds was 42.2% in the five years ended Sept. 30. The non-insured funds returned 39.6% on average. So the insured bonds’ values appear to have held up better, more than compensating for the lower yields.

However, year-to-date through Sept. 30 California insured funds were up 0.78% while non-insured funds were up 1.14%. All bond funds have seen poor total returns this year because market interest rates have risen, depressing principal values.

Still, if it’s a higher current yield you’re looking for, you’re clearly better off in a non-insured fund.

Some of the top-performing non-insured California funds this year include the Federated California Muni Income Fund, with a total return year-to-date of 4.03% and a current yield of 5.52%.

The Franklin California High-Yield fund has posted a return of 3.81% so far this year and has a current yield of 6.55%.

As for insured funds, the top performer so far this year is the Merrill Lynch California Insured Muni Fund A, with a total return of 2.52% and a current yield of 5.15%.

The Vanguard California Tax-Free Insured Long-Term fund is up 2.32% in total return so far this year and has a current yield of 5.33%.

So why accept smaller returns when you don’t have to? Belts and suspenders can be awfully cumbersome.

Debora Vrana can be reached at [email protected]

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California Municipal Bonds

T. Rowe Price & Associates tracks the yields of 20 California municipal bonds and the Bond Buyer Index of 40 national issues.

Bond Buyer 40-bond Index

October 1996: 5.91%

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California Index

October 1996: 5.81%

Five widely held California bonds:

Issue: California general obligation 10-year

Coupon: (generic)

Maturity: (generic)

10/18 Yield: 5.05%

10/25 Yield: 5.05%

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Issue: California general obligation 20-year

Coupon: (generic)

Maturity: (generic)

10/18 Yield: 5.63

10/25 Yield: 5.70

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Issue: Los Angeles Metropolitan Transit Authority (insured)

Coupon: 5.00%

Maturity: 7/1/2017

10/18 Yield: 5.70

10/25 Yield: 5.80

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Issue: California public works lease revenue

Coupon: 6.00%

Maturity: 10/1/2014

10/18 Yield: 5.80

10/25 Yield: 5.80

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Issue: San Francisco airport (insured)

Coupon: 5.65%

Maturity: 5/1/2024

10/18 Yield: 5.75

10/25 Yield: 5.85

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Source: T. Rowe Price & Associates in Baltimore, which manages a $150-million California bond fund.

Note: All yields are as of 2 p.m. Friday. Yields are based on institutional trading, retail prices and a survey of California brokers. Yields offered to individual investors will vary.