The Two Sides of Muni Bonds -- Part II

This article originally appeared on The DIV-Net on Nov 24th, 2009.

Last time, we talked about what to look for in municipal bonds and their two sides of risk. Now, let's jump right into a few examples.

The safe side

California St. GO Bonds, 2036 4.5% (CUSIP 13062TSB1). These are general obligation of the state of California and pay interest semi-annually at a 4.5% annual rate. As GO bonds, they are backed by the full taxing authority of the state. They're currently trading for around $80 on face value of $100, for a current yield of around 5.6% (4.5%/80=5.6%) and an yield to maturity of about 6%. Just back in July, they traded for $76 and for the last month or two had been trading for $90. Since they're long-term bonds (mature in 2036), the price can fluctuate a lot, based on expectations of inflation, interest rates, and perceived risk.

I found them interesting enough to buy a small amount for $83 back in April. Now at $80, they still seem attractive given the current alternatives.

The risk is that California won't pay its debt. The state is in big trouble, so the risk is real.

The unsafe side

On the dark side, we have revenue bonds whose underlying project went bankrupt.

California Special Tax Diablo Grande, 2014 4.64% (CUSIP 958324CF0). At first glance, this seemed like an interesting opportunity. It's due soon, less than 5 years out, and is currently trading for $62, which means a current yield of over 7% tax-free and an yield to maturity of over 16%.

But consider the risks. These bonds are backed up by a special tax imposed on the Diablo Grande community, a new planned development in California expected to be home to between 5,000 and 10,000 families, businesses, club houses, winery and golf courses. However, due to various legal disputes and the housing downturn, only 400 houses have been built to date. Over 70 of them have been foreclosed. No businesses operate there yet other than the golf courses.

The downside protection is that the state can foreclose on a property that doesn't pay its special taxes. However, there can be no assurance that people won't simply walk away from their devalued properties. If there aren't enough people paying the taxes, the bonds will default.

The developer of the community went bankrupt last year. Recently, a new buyer stepped in and agreed to turn around the operations and re-open the then closed golf courses and club houses. According to local news, the site is operational again, but still there aren't many families and businesses paying the special taxes that support the bonds.

The bonds currently trade for $62 and have been as low as $39 during bankruptcy. The MSRB site does not show any special material events, so I assume the interest is still being paid.

This is one case of high-risk high-reward investment. For the time being, I'm not investing in these bonds until I can confirm how much tax income is available to support the interest on the bonds. A call to the underwriter is in the cards as my next move.

Important note: In investing, there's no such thing as a true safe investment. So, when I classify munis into "safe" and "unsafe", these are both relative terms. It's very possible that "safe" bonds get defaulted on.

Disclosures: I own 13062TSB1 at the time of writing.

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