Should L.A. County Muni Bondholders Be Worried?

It isn’t getting any easier to be an investor in California municipal bonds.

On Wednesday, a major Wall Street credit-rating agency downgraded Los Angeles County’s $4.4 billion in long-term bonds for the third time since 1992.

With memories of Orange County’s bankruptcy still fresh, the L.A. County downgrade is certain to fuel nervousness among individual investors--who directly or through mutual funds own the bulk of tax-free muni bonds in California and nationwide.

How concerned should investors be? Here’s a primer on Los Angeles County’s situation and on California munis in general:

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Q: Why were the county’s bonds downgraded?

A: The cut in the county’s credit rating by Moody’s Investors Service was a response to the tenuous $12-billion 1995-96 budget the county supervisors patched together last week.

The bond raters base their quality grades largely on an issuer’s ability to pay its bills, including interest on its bonds. Because the county’s budget includes as much as $300 million in revenue the county isn’t yet sure it will get, Moody’s is concerned that a deficit still exists--despite the county’s deep cost-cutting to make ends meet.

But Moody’s also said the downgrading reflects its long-term worries about the county’s finances.

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Q: What are those long-term worries?

A: The county, like other California municipalities, faces the ultimate responsibility for health care services, welfare and other social services at the local level. But its ability to raise revenue is constrained by property tax limitations and borrowing restrictions.

At the same time, state and federal funding to the county has been slowed or reduced in recent years, and that situation could worsen, given the conservative political climate. As County Supervisor Zev Yaroslavsky notes, “All counties [in California] have these problems in one way or another.” But as the nation’s largest county--with a huge population of poor residents and a still struggling economy--L.A. County feels the effects in spades.

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Q: So how safe are the county’s bonds?

A: Moody’s reduced its rating on the biggest portion of the county’s debt to Baa1 from A. That covers the county’s pension-obligation bonds and, most significantly, its fixed-asset leases, or certificates of participation (COPs). Those fixed-asset COPs are bonds previously sold to finance county buildings, such as jails and courthouses.

The Baa1 rating level means the bonds now are considered “medium grade” in quality, which is two notches above the speculative, or “junk” level.

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Q: Does that mean my interest payments are threatened?

A: At this stage, no. In fact, Moody’s specifically said that its downgrading should not be construed as a warning that the county is near bankruptcy, or is likely to renege on its debts.

Along with the downgrade on the pension bonds and COPs, Moody’s cut the county’s $70 million in general obligation bonds from A1 to A. General-obligation debt ratings often are considered a benchmark for muni issuers. That A rating is a symbol of “a financially stable entity that wants to remain stable,” said analyst Ken Kurtz at Moody’s.

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Q: Then why should investors wring their hands over the downgrade?

A: Because the market reacts to ratings cuts. The lower a bond’s rating, the higher the yield it must carry to cover the risk investors perceive, even if the chance of default remains minuscule.

For example, the average yield on A-rated five-year muni bonds nationwide now is 4.7%, while AAA-rated bonds of the same term average 4.4%, according to Municipal Market Data.

As the county’s bond ratings decline, the market prices of its outstanding bonds also decline, thereby pushing yields up for new buyers. Quite simply, that means current owners of the bonds might be surprised at the relatively low prices they might get if they choose to sell today.

“There’s always a bid [for the bonds], but not necessarily a bid anybody wants to sell at,” says Robert Gore, muni trader at brokerage Crowell Weedon. As a result, he says, “L.A. paper is moving very slowly.”

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Q: If I own Los Angeles County bonds, should I just hold on?

A: Many experts would probably advise that. Few believe that the state of California could afford to have two of its major counties become deadbeats--hence, there is a feeling that the potential for Los Angeles County to renege on its debts, no matter how dire its situation, remains low. Also, if your bonds are privately insured--and many county bonds are--you needn’t worry.

Still, bondholders must realize they may have to ride through a long period of uncertainty about the county’s health. And muni bonds’ market prices may be further depressed if federal tax reform ideas advance, making all munis less attractive.

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Q: What if I own California muni bond funds?

A: Many fund managers have already bailed out of Los Angeles County bonds in favor of higher-rated issues, just to avoid controversy. And despite concerns about California bonds in general this year, California muni funds’ total returns (interest plus principal gain) are better than national muni funds, on average--though that partly reflects California funds’ rebound from a poorer performance in last year’s bond market rout, which was made worse for California bonds by Orange County’s bankruptcy in December.

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The Cost of a Downgrade

Seemingly minor gradations in municipal bond credit ratings can translate into significant differences in the yields investors demand on the bonds. Here are current generic yield “spreads” for bonds of varying quality:

Rating / 5-year muni yield:

AAA: 4.40%

AA: 4.50%

A: 4.70%

Rating / 15-year muni yield:

AAA: 5.60%

AA: 5.70%

A: 5.85%

Source: Municipal Market Data

Muni Funds: A Sampling

Here are total investment returns (interest earned plus or minus change in principal) for some major California municipal bond funds in 1994 and through July of this year, along with average returns by fund category: *--*

Total inv. return 1994 1995* Smith Barney Cal. A -5.7% +13.6% Fidel. Cal. Insured -10.2% +10.8% Sierra Cal. A -8.6% +10.6% Putnam Cal. A -6.7% +10.6% Vanguard Cal. Ins. Long -5.7% +10.5% Franklin Cal. Insured -5.3% +9.6% Franklin Cal. -2.8% +8.9% Dean Witter Cal. -6.0% +8.3% Dreyfus Cal. Tax-Ex. -7.1% +7.9% Avg. Cal. insured fund -8.5% +10.5% Avg. Cal. fund -7.5% +10.3% Avg. general muni fund -6.5% +9.7%

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* through July 31 Source: Lipper Analytical Services