ETFs And A Calif. Muni Storm
May 15, 2012
California’s massive deficit problem may have caught politicians by surprise, but ETF investors needn’t be caught so flat-footed.
For municipal bondholders, California’s “shocking” $16 billion deficit is a startling development that should raise major red flags about the state’s ongoing ability to service its debt.
So, ETF investors who hold muni bond funds need to understand the ways they can protect themselves.
Whether that means steering clear of California altogether or finding a broad ETF less larded up with muni bonds from the not-so “Golden State,” the market of muni-focused ETFs is deep enough for investors to have real options.
That said, finding those options does take some work, as the most populous U.S. state casts a long shadow in the muni market.
But make no mistake: As California governor Jerry Brown looks for ways to close a nearly $16 billion dollar budget deficit, the proposed solutions may well exacerbate an already big problem. And, the ramifications for the muni bond market could be profound.
After all, California is not only the largest issuer of municipal bonds in the U.S., it has the lowest credit rating of any state in the union—an unwanted distinction if ever there was one.
At the root of the problem is the fact that the unexpected jump in the state’s budget deficit stems from lower-than-expected revenues, the lifeblood of debt service.
Avoiding Obvious Pitfalls
As I said, it’s hard to hide from California municipals in broad portfolios, and that’s because so many bond indexes are market weighted, and the state is the largest issuer in the country.
If you’re concerned about the sustainability of California’s debt, avoiding for now the three California-focused muni ETFs would be an obvious place to start—the iShares S&P California AMT-Free Municipal Bond Fund (NYSEArca: CMF), the PowerShares Insured California Municipal Bond Portfolio (NYSEArca: PWZ) and the SPDR Nuveen Barclays California Municipal Bond ETF (NYSEArca: CXA).
These portfolios have had a huge run since Meredith Whitney’s scathing analysis prompted a sell-off in municipal bonds at the end of 2010, so it takes real conviction to unload them now.
Perceived Risk Grows With Time
Even if you’re not ready to sell such holdings, it’s worth noting that of the three portfolios, CMF has the lowest effective duration and therefore the lowest interest-rate risk of the group. That’s crucial should you be concerned about the state’s longer-term outlook.
After all, with a higher duration comes more uncertainty. It also means you have to wait longer to get your money back. Securities with a longer time to maturity have more sensitivity to changes in credit risk expectations; thus, California does not need to default for investors to be punished. They only need to see a change in the expectations of a default to get hammered.
The chart below highlights this dynamic.
Below are the yield curves for the three most heavily weighted states in the broad-based iShares S&P National AMT-Free Municipal Bond Fund (NYSEArca: MUB)—California, New York and Texas—plus the U.S. Treasurys yield curve.
It’s clear from the graph that short-term California paper is actually considered safer than that of Texas or New York.
But as you move farther out along the curve, it becomes increasingly clear that investors are concerned about the sustainability of California’s debt service abilities. Thus spreads widen considerably.