California and its local governments have long counted on a large captive audience for their debt: Many of the buyers are high-income individual investors who live here and find the federal and state tax exemption on California municipal bond interest too attractive to pass up.
This has been one case where having most of your eggs -- or at least your bond eggs -- in one basket seemed defensible. After all, municipal bond defaults have always been rare events.
They still may be relatively rare for a long time to come. Even so, after years of fiscal tumult in the state, financial advisors to some of California's well-heeled investors have a very different attitude toward muni bonds today than they did, say, a decade ago.
Most high-income clients at Hokanson Associates, a wealth manager in Solana Beach, now have no more than half of their muni bond portfolios in California issues, says company founder Neil Hokanson.
The rest is spread among muni bonds of issuers outside California -- typically in what are known as unlimited-tax general obligation bonds, whereby the issuer pledges to raise taxes as high as necessary to protect payments to debt holders.
Diversification into non-California munis has a cost, Hokanson concedes. Golden State investors must pay California's steep income tax (as high as 10.55%) on interest earned on out-of-state muni bonds. And yields on bonds of financially healthier muni issuers naturally are lower than what can be earned on the debt of California itself, which has the poorest credit rating of any state.
But Hokanson, whose firm oversees about $350 million, says his decision a few years ago to diversify into out-of-state munis fits with what he says is clients' No. 1 concern these days. "They say, 'We're more worried about losing money than not making money.' "
Let me say right here: I am not about to suggest that the California muni market faces some immediate calamity, or even eventual calamity. Plenty of investors have been doing quite well with their California munis (state and local issues) for years, in the face of what have been increasingly dire forecasts about some issuers' ability to pay.
The more dire the forecasts, generally, the higher the interest rates investors demand. The state's next big test of that demand will come next week, when Treasurer Bill Lockyer will use a network of brokerages to sell $2 billion in general obligation bonds to fund voter-approved infrastructure projects.
I'll hazard a guess that, five years from now, the state and the vast majority of cities, counties, school districts and other bond issuers in California still will be paying bond investors in full and on time.
Nonetheless, if there ever was a time for California muni investors to take a close look at what they own, this is it.
Why? First, there is no minimizing the challenge government units face from yawning budget gaps, depressed property values, huge long-term pension liabilities for public workers and doubts about the economy's ability to produce badly needed, tax-revenue-generating jobs in the private sector.
These are national issues, not just California issues, of course. But they are as serious here as anywhere.
Second, if interest rates rise across the board in the next few years, for whatever reason, outstanding fixed-rate bonds are likely to be devalued. If you own individual muni bonds that you worry would be difficult to sell in today's market, having to sell them in a time of higher rates could be much more problematic.
If you're trying to evaluate your comfort level with California muni bonds, start with these three questions:
Did you buy bonds for the wrong reasons? Let's face up to this muni market reality: Most people buy what a broker sold them, not what they picked out on their own. That's why many individuals end up with a lot of bonds from small government issuers or agencies, of which there are thousands in California.
Marilyn Cohen, head of money manager Envision Capital Management in Los Angeles, says one new client came to her recently with a bond portfolio that encompassed 67 different California issues.
"Some of these issuers haven't even put out financial statements since 2007," Cohen said.
If California has entered an extended period of fiscal stress, the time to identify high-risk bond issuers is now. If the only thing you know about an individual bond is that it pays a lucrative tax-free yield, chances are you don't know enough.
Want some objective advice on munis? Consider a subscription to the independent California Municipal Bond Advisor newsletter, which focuses solely on in-state bonds. Online, go to: www.californiabondadvisor .com.
What does bond diversification mean to you? The double tax exemption on California muni interest has given many investors all the justification they need to rely exclusively on in-state munis for the bond portion of their portfolios.