Talk about Money: A dicey time to bond

A lot of high-income people live in Scotts Valley, and they pay a lot of taxes.
Investors in high tax brackets have long been attracted to municipal bonds, because the interest they pay is exempt from federal taxes and, in many cases, state income taxes, too. But as California’s economy’s sputters, the reliability of its bonds is being questioned.
Let’s start with the basics. First, what is a municipal bond?
Municipal bonds are debt securities issued by states, cities and other local government entities to raise money for public purposes. Investors who buy municipal bonds are lending money to a state or local government, just as investors who buy U.S. savings bonds or Treasury bills lend money to Uncle Sam.
Most bonds pay set interest and mature on a set date.
Let’s say you buy a $10,000 municipal bond with a maturity date of Dec. 1, 2029, and an interest rate of 5 percent. That bond will pay you $500 a year (5 percent of $10,000) in interest and then give you back your $10,000 at maturity. During the 20 years of the bond’s life, its price will fluctuate, but as long as the issuer remains solvent, you’ll get $500 in interest payments per year and $10,000 back at maturity.
If there are worries that the issuer will have trouble making its payments, the value of its bonds will drop, and if it wants to borrow more money by issuing more bonds, it will have to pay higher interest rates.
That’s what has happened in California. Long-term bonds issued by the state pay interest rates that are much higher than U.S. Treasury bonds. That’s unusual. States and cities have historically been able to borrow at lower rates than the U.S. government, because municipals pay no federal tax on interest, while Treasury bonds pay interest that is federally taxable.
But the relatively high interest rates on municipals reflect fear about California’s ballooning budget deficit. The collapse of home prices and a surge in unemployment has cut revenue to state and local governments. So the state and cities in the state must pay higher interest rates when they borrow.
One California city, Vallejo, defaulted on its municipal bonds this year.
Some experts say the situation may worsen and the prices of municipals may drop further. One of them is James Chanos, a famed short-seller who was among the first to predict the collapse of Enron Corp. early this decade.
The “cracking of state and local municipalities is coming,” Chanos told Barron’s financial weekly last month. The problem isn’t only the reduced revenue caused by recession — it’s also out-of-control health care costs and decimated retirement funds for public workers.
He says state politicians believe that in “a worst-case scenario, the federal government will bail them out.” If the feds do bail out California, and bonds issued by the state become obligations of the U.S. government, those bonds would lose their federal tax exemption, Chano says, and that would probably send their prices tumbling.
In the past, municipal bonds have enabled high-income investors to sleep soundly, but those days may be over.
• Mark Rosenberg is an investment consultant for Financial West Group in Scotts Valley, a member of FINRA and SIPC. He can be reached at 439-9910 or mr********@fw*.com.