Is California Dreamin'?

For most investors, the stock market is the first place to look for signs of problems in the economy. But another, less popular financial market has been spooking investors for quite a while now, and it's not showing any of the signs of improvement we've seen in other investments.

With the stock market having rallied so strongly over the past year, you'll find the new proving grounds for the economy in the municipal bond market. Especially in hard-hit places like California, muni bonds are showing just how seriously investors are perceiving problems. Just by looking at bond prices and yields, you can see the struggles that state and local governments are having to deal with, as the effects of the falling housing market and the economic slowdown have trickled down gradually.

Boring no more
When you think of exciting investments, municipal bonds aren't supposed to show up anywhere near the top of the list. Backed by the power of government entities to raise revenue through sources like income and property taxes, as well as public services like water and sewer bills, municipal bonds are typically seen as relatively safe investments that provide a modest but dependable stream of income.

In fact, the primary consideration for municipal bonds is that their interest isn't subject to federal income tax. In addition, if you live in the state that issues the bonds you buy, then you won't have to pay state income tax on the income they generate either. That makes municipal bond income especially attractive, since with other bonds, you can lose as much as 35% of your income to federal taxes, plus whatever your particular state charges on top of that.

But investors have lost confidence in municipal bonds, having bid down prices to the point where even yields on AAA-rated government debt are far higher on a tax-equivalent basis compared to U.S. Treasury bonds with the same maturity. And as the Wall Street Journal reported recently, California has seen its debt ratings fall to the point at which its bonds are seen as an even riskier bet, with investors demanding over 1.5 additional percentage points for the state's municipals.

What's going on?
The concerns that people have about California are pretty easy to understand. Seen as the epicenter of the housing crisis, California has long been plagued by foreclosures and mortgage delinquencies.

Moreover, the business climate for companies in California hasn't been especially good. Many California-based companies have seen their revenues fall substantially during the recession, including the following:

Source: Capital IQ, a division of Standard and Poor's.

Granted, just because these businesses are based in California doesn't mean that the state will bear the entire brunt of their woes. But the problems that California-based companies face hits the state two ways. They can have a huge direct impact on the taxes that the companies themselves pay. In addition, if these companies have to cut pay or lay off workers, then it can spell falling personal income tax revenue from employees who live within the state.

A tale of two markets
One of the most compelling things about California's current situation is that investor interest in bonds generally has never been higher. Low interest rates and the concerns many have about the stock market have both created unprecedented demand for bonds and bond mutual funds, ranging from Treasuries to relatively risky corporate debt.

Yet many of the same arguments that keep people buying other types of bonds hold equally true for municipal bonds. The tax advantage that munis enjoy could be even more valuable over time, if worries about higher income taxes come to pass. And although state and local governments clearly face difficult challenges, they're the same sort of challenges that both the federal government and private companies are dealing with.

Is California a bargain?
As a result, muni investors should ask themselves the same question prospective homebuyers have been for some time: is California finally cheap again? With financial markets of all sorts potentially overheating, municipal bonds may offer one of the last decent values out there -- and at the very least, they're worth a closer look for those trying to draw income from their portfolios.