The California Bond Rush

What is it about California? Somehow the land of movie-star Governors has managed to get people excited about municipal bonds those investment workhorses that pay for new schools and sewers and earn you tax-free income all at the same time. The big show in the muni market this year is the Golden State's $15 billion offering, the largest in the nation's history and the presumptive first step in curing California's severe fiscal woes.

If you're a muni holder, you may have already felt the impact, even though the first wave of new bonds isn't likely to hit the market until this summer. Just the promise of a new supply can drive down prices on current bonds. Yields, which move in the opposite direction of prices, generally rose the day California voters green-lighted the bonds.

That has been a familiar story the past two years, as U.S. states have refilled depleted coffers by taking advantage of low interest rates to roll out a record number of munis. In 2002, $430 billion of munis were sold, according to the Bond Market Association, the most ever in a single year until 2003, that is, when $452 billion worth hit the market. That flood of paper has helped keep muni yields high relative to Treasuries and has provided a nice windfall for yield-seeking investors.

While that spread has narrowed since last year, the average 10year general-obligation AAA-rated muni still yields 88% of what the 10-year Treasury note does. Since investors generally don't pay federal tax on interest from munis (or state or local tax when they live in the issuing state or municipality), that muni's recent 3.69% yield feels like 5.13% to a taxpayer in the 28% bracket, compared with the taxable Tnote's 4.20%. And that's before taking into account any exemption from state and local tax. "Yields are still cheap compared to Treasuries'," says Zane Brown, director of fixed-income investments at Lord Abbett. Baby boomers in peak earning years are especially well positioned to reap the tax benefits of munis, says Brown, who recommends high-quality bonds, rated AA or AAA.

Research, though, can be a slog. InvestingInBonds.com has prices as well as a calculator to compare taxable and tax-free yields. But there are about 1.4 million muni issues trading, so it's hard to keep everything straight. Another downside: you have to pony up about 2% of the bond's value when you execute the trade, according to a recent study by the Securities and Exchange Commission's chief economist.

One alternative is muni mutual funds. You pay an average 1.09% in management and other fees each year, but you receive a diversified portfolio in return. Many muni funds buy nationally, though a fair number specialize in munis from specific states, particularly high-tax states such as California and New York, which are generally best for folks living there.

When shopping for a fund, look first at duration, a measure of interest-rate sensitivity. The longer the duration, the higher the yield but also the higher the chance the underlying bonds will lose value when rates rise. A fund with an average duration of five years loses about 5% of its value for every percentage point that interest rates rise. Eric Jacobson, a Morningstar analyst, recommends Fidelity Spartan Intermediate Municipal Income for buy-and-hold investors with middle-of-the-road risk tolerance or T. Rowe Price Tax-Free Short-Intermediate for more risk-averse investors. Since interest rates have little direction to go but up, he suggests "dollar cost averaging," or buying a set dollar amount of shares at regular intervals. Also, since funds constantly buy and sell individual bonds, they can sock you with capital gains, which, unlike interest, aren't tax free. Funds with stellar tax efficiency include Vanguard Intermediate-Term Tax Exempt and Franklin Federal Tax-Free Income.

And if you want to get in on the California action? Pull up a chair. Lehman Bros. is still working out the details of the deal, including the bonds' duration and when they will be sold. And then you can be sure Arnold will be out there pitching.