Recently, Ive been taking another look at investing in California municipal bonds. Even if you dont live in California, the yields can be quite attractive. But is it a good idea?

Tax-Equivalent Yields

Right now, the Vanguard California Intermediate-Term Tax-Exempt Fund (VCAIX ) has a yield of 3.49% with an average maturity of 7 years. In addition, since the interest from this fund is exempt from both federal and California state income taxes, the equivalent taxable yield is actually much higher. You can use a tax-equivalent yield calculator to find out how it works out for your tax brackets.

If you are in the 33% federal tax bracket and 9.3% CA bracket, that 3.49% would be the same as a taxable bond yielding 5.74%. Even for an out-of-state investor, the federal tax exemption alone gets you to 5.21%. which is higher than many mortgage interest rates.

If you are in the 25% federal tax bracket and 9.3% CA bracket, that 3.49% would be the same as a taxable bond yielding 5.13%. For an out-of-state investor, the equivalent yield is 4.65%. As you can see, these yields are definitely more attractive for those in higher tax brackets.

Safety Concerns

Is this reckless rate chasing? Lets look at a few articles on California munis by Vanguard. Schwab. and Fidelity. Here are some highlights:

• Youre nearly first in line. Californias constitution requires that state general-obligation bond payments take priority over other payments except for those that fund education. This means as a bondholder youre ahead of other government employees, firefighters, and basically everyone else.
• Diversify. If you do invest, dont make it all of your portfolio. There is still some risk. You can still hold other national muni funds, US. Treasury bonds, and investment-grade corporate bonds.
• Buy a bond fund. I would invest in a managed municipal fund and not in individual securities unless I was very experienced. You dont want to have to navigate a minefield of call risk, GO bonds, bonds based on sales tax revenue vs. utility fees, and other tricky details.

Holding Period Concerns

Its important to note the maturity and duration of the bonds youre buying, because if you have to sell sooner than the average maturity, youll be greatly exposed to price volatility. For example, if Californias credit rating drops further, then the current market value of the bonds you buy will also drop. If you sell early, youll have to take a loss. However, if you are able to hold a bond until maturity, youll still get the fixed yield and the principal back, so it wont affect you.

Also, if you sell early and the bond value has increased, you may be subject to capital gains taxes from which you are not exempt.

My Personal Opinions

Ive been keeping track of all the ways the state of California has been trying to manage this budget shortfall, and it is clear they are ready to take some very drastic steps to cut expenses. In any event, I fail to see how the U.S. government would not bail out California if things got really bad. If private corporations can get bailed out, why not a state full of voters? Im not alone, however, as these bonds have been rallying as of late.

I am thinking of investing in California municipal bonds for a very specific scenario: I would buy them instead of paying down my mortgage further, as the tax-equivalent interest rate from the bonds is actually higher than my (tax-deductible) mortgage interest rate. This way, I both come out ahead in terms of interest and I have good liquidity if I wish to access the money for some reason. I also dont see myself as taking too much extra risk, as I would with a stock fund for example.