There are two primary types of risk associated with municipal bonds.
The first is "interest rate risk," which is the risk that interest
rates will rise and new bonds will pay more interest than existing
bonds. The second is "credit risk," which is the risk that the
government agency that issued the bond will be unable to make interest
payments or repay the principal when the bond matures.
The phenomena you have observed is not one where California municipal
bonds are "defying gravity" by not responding to the rise in interest
rates. Instead, you are observing investors responding to the state's
improved financial position. As a result, the decrease in credit risk
is more than offsetting the rise in interest rates. However, if
interest rates continue to rise and adversely affect California's
economy, then credit risk will rise and California municipal bonds
could decline.
California has also decreased the amount of bonds it is issuing
because its revenues have increased. The decrease in supply has
increased demand for the remaining bonds outstanding. This situation
could reverse if the state's finances decline, which would potentially
put pressure on California municipal bond prices.
I have provided a number of sources below that describe both general
risks associated with municipal bonds and the state of the market for
California municipal bonds. As you will learn, investor demand has
been so strong for California municipal bonds that closed-end funds
like BZF and AKP are actually trading at a substantial premium to the
fair value of their holdings. Less than a year ago, these same funds
traded at a discount, which suggests that investor sentiment can be
volatile.
Sincerely,
Wonko
"Alliance CA Municipal Income Fund (AKP)" Nuveen Investments (June 30,
2006) http://www.etfconnect.com/select/fundPages/muni.asp?MFID=82652#Share%20Price%20and%20NAV%20History
"BlackRock California Municipal Income Trust (BFZ)" Nuveen investments
(June 30, 2006) http://www.etfconnect.com/select/fundPages/muni.asp?MFID=76470#Share%20Price%20and%20NAV%20History
"You can figure it out. Say interest rates have gone up from 5% to 6%
since you bought the $5,000 bond. Anybody who buys the bond from you
will still get $250 a year in interest. But who'd want your bond at
$5,000 if the new bonds are paying 6%, or $300? You would get about
$4,166 for your bond, which at 6% would produce $250.
That's what's called the "interest rate risk," the chance that your
bond will go down in value if interest rates go up. Of course, they go
up in value if rates go down, as Merrill Lynch predicts. And if you
hold a bond to maturity, you get back what you paid.
Another risk is credit risk - that the government agency that issued
[t]he bond won't have the money to pay you the interest, or give you
back your money at maturity. Ever heard of Orange County? Investors
lost a staggering $1.7 billion when the California county went into
bankruptcy."
"TAX FREE STATUS A BONUS WITH MUNICIPAL BONDS" By Humberto Cruz,
Bondsonline Group (2006)
http://www.bondsonline.com/asp/muni/igtaxfree.asp
"Rising interest rates sank the total return performance of municipal
bond mutual funds that were too heavily weighted in long-term bonds
during the second quarter."
"Sinking Feeling for Funds" by Christine Albano and Jacob Fine, The
Bond Buyer (July 12, 2006)
http://www.bondbuyer.com/article.html?id=200607112TPMNXRI&from=home
"Another sector that performed well: bonds within the state of
California. By that I mean bonds sold by entities within the state but
not California general obligation bonds. If you look at the Lehman
indices of performance per state, bonds within California outperformed
those from every other state in the country. We can thank the healthy
economy and the increase in tax revenues within the state. "
"Bob Fields Discusses the Outlook for Municipal Bonds" PIMCO (March
2006) http://www.pimco.com/LeftNav/Product+Focus/2006/Bob+Fields+Interview.htm
"Rising short-term interest rates drove short-term bond yields higher
and their prices lower. But at the same time, long-term bond yields
declined during much of the past 12 months and their prices rose a
bit, helping to keep the California muni bond market's returns in
positive territory. Another factor at work was tightening credit
spreads - meaning there was a narrowing of the yield gap between high-
and low-quality bonds, reflecting investors' strong appetite for yield
and their willingness to take on more credit risk to attain it. The
California muni market outperformed the national muni market thanks to
in-state investors' robust appetite for bonds free from both state and
federal taxes. There also was good national demand for California
munis, fueled largely by the improving credit profiles of many muni
issuers across the state as economic conditions and revenues generally
strengthened."
"Fidelity California Municipal Income Fund Shareholder Update"
Fidelity investments (February 28, 2006)
http://content.members.fidelity.com/epro/SHU/316061209/?format=HTML&app=RETAIL&part=CONTENT#ref693
"California & High-Yield Municipals Outperformed
On a state-specific level, California municipal bonds narrowly
outperformed national averages as California-based supply dropped by
more than 20% compared with the first three months of 2005: the Lehman
Brothers California Municipal Bond Index rose +0.37% for first quarter
of 2006, outpacing the gain of the Lehman Brothers Municipal Bond
Index by 12 basis points. In addition, long-term and high-yield
municipals posted the quarter?s biggest returns: the Lehman Brothers
Non-Investment Grade Municipal Bond Index advanced +2.41% and the
22-year-plus portion of the Lehman Municipal Bond Index rose +0.75%."
"Quarterly Commentary -- California Long-Term Tax-Free Fund" American
Century Investments (Q1/2006)
https://www.americancentury.com/funds/fund_commentary.jsp?fund=932
"The Tax-Exempt Market
In aggregate within the U.S., states have experienced strong revenue
growth over the last year, which has created a solid fundamental
environment for the municipal market. Increased revenues have
contributed to a reduction in issuance of new debt, which has improved
market technicals. With demand high, municipals outperformed most
taxable sectors before adjusting for any tax benefit during the
quarter.
Nearly all states recorded revenue increases well above fiscal year
projections, leading to the most financial flexibility seen in the
last five years. State budgets are more balanced today, and many have
begun to rebuild reserves. Steady economic growth, increased corporate
profits, a solid real estate market, and stock market gains have all
been important drivers of strong revenue. Looking ahead, state
financial projections are cautiously optimistic.
With improving tax revenues, states have less of a need to borrow
externally for cash flow purposes. This resulted in a 29% decline in
new issue supply during the quarter, which has improved market
technicals. Demand has been heaviest from high net worth individuals
and insurance companies. This is a change from years past, as record
levels of new issue supply previously led to a cheapening of the
sector and strong buying by alternative/crossover accounts."
"BlackRock Closed-End Funds Quarterly Performance Update" BlackRock
(First Quarter 2006)
http://www.blackrock.com/funds/cefunds/ALL_qtly.pdf
"Municipal Market Recap & Outlook" by David S. Altshuler, Nuveen
Investments (Second Quarter 2006)
http://www.nuveen.com/etf/web_files/Investment%20Research/muni%20market%20recap%202Q06.pdf
"State of California Credit Update" by David Blair, Nuveen investments
(November 18, 2005) http://www.nuveen.com/etf/web_files/Investment%20Research/CA%20Commentary%2011-05.pdf
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