California muni investors trim holdings

Financial advisers with clients in California are increasingly recommending a cutback in exposure to the Golden State's tax-exempt bonds. Considering California's high income taxes, that is a tough recommendation to make, but many advisers say that the state's perilous fiscal condition — worse than that of other troubled states, including Illinois and New York — will continue to pressure California bond prices. “My clients are nervous, and I am very nervous,” said Marilyn Cohen, president and chief executive of Envision Capital Management Inc., a Los Angeles-based firm that oversees $250 million in bonds for individuals. “Nothing has materialized to give us any confidence that this is going to be handled,” she said, referring to California's budget crisis. Ms. Cohen is cutting back her clients' exposure to California bonds and instead putting the money to work in more financially stable states, such as Texas. Although the interest on those bonds won't be exempt from state or local taxes, they will be exempt from federal taxes, she said. “That's exactly the course we're following,” said Jack H. Scaff III, vice president of Brouwer & Janachowski LLC, a Tiburon, Calif.-based firm with $800 million under management. California is running a $20 billion deficit, but because its constitution gives top priority to debt service, default isn't his biggest fear. “Our largest concern is the credit perception,” Mr. Scaff said. “How will downgrades affect bond prices?” Brett Thomas, a principal with Capital Performance Advisors LLP, a Walnut Creek, Calif., adviser with $700 million under management, agrees that downgrades are more problematic than the threat of default. And given the likelihood of more downgrades, he isn't willing to put his clients' assets at risk. “I'm not buying a lot of fixed income these days from California,” Mr. Thomas said. Municipal-fund managers and analysts say that they understand where advisers are coming from. California is in a “very dire” situation, said Linda Murphy, an analyst with T. Rowe Price Group Inc., who said that her firm isn't a “net buyer of state bonds.” Instead, to make sure that the $324.49 million T. Rowe Price California Tax-Free Bond Fund (PRXCX) owns something, she is leaning toward water and sewer bonds that back needed services. “Investors who can stomach the headline risk, and have a longer-term outlook, might look at [the current environment] as a good opportunity,” said Paul Brennan, a muni-fund manager with Nuveen Investments LLC. But many advisers said that their clients are in no mood to take chances with the portion of their portfolio that is supposed to come with relatively little risk. In fact, some advisers said that while California faces the biggest challenges, fiscal problems in other states are forcing them to re-evaluate the use of muni bonds in general. Illinois and New York, for example, face deficits of $5.7 billion and $7.4 billion, respectively, noted Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management LLC, an Oak Brook, Ill.-based firm that manages $13 billion in assets. “There are a lot of negative situations,” he said, adding that conditions will get worse due to high unemployment, which depresses state income tax and sales tax revenue.

STIMULUS A DOWNER

Ironically, buyers of conventional tax-exempt municipal bonds have been put at a disadvantage by the success of the federal Build America Bonds stimulus program, which seeks to spur construction and repair projects on the state and local level by subsidizing the interest on taxable muni bonds. More than $64 billion worth of Build America Bonds were issued last year, beating initial forecasts for $50 billion in sales. Had the program not existed, many of these bonds would have been issued as conventional munis. As a result of the program, the supply of high-quality tax-exempt municipal bonds is being “zapped away,” Mr. Ciccarone said. E-mail David Hoffman at dhoffman@investmentnews.com.