July 1 (Bloomberg) -- Time for some California dreaming: Will the state plug its budget gap, and are its bonds worth a gamble?

Matt Fabian, managing director of Municipal Market Advisors in Concord, Massachusetts, says yes. As California hurtles toward its budget deadlines this month, interest rates on its tax-free bonds have jumped. Residents can get yields north of 5 percent on intermediate-term general obligation bonds and 6.2 percent on long-term bonds. Nonresidents will find them in many national municipal funds, which buy the bonds of many states.

Warren Pierson, senior portfolio manager of the Baird Intermediate Municipal Bond Fund in Milwaukee, says no to the country’s fiscally weakest state. California’s credit rating could drop to BBB from A today, he says, raising yields even further. “We would then most likely get involved.”

The California mess confronts the question of what it means to be an income investor today. Ten-year AA-rated general obligation bonds, backed by the issuer’s taxing power, are yielding an average of 4 percent, down from 5 percent six months ago. To get 5 percent today, investors generally need A-rated bonds or lower, or issues that aren’t rated at all.

At lower-quality levels you face more risk, which generally means buying a muni mutual fund for diversification. Owning a portfolio of funds is safer than gambling on just a few issues.

Defaults on munis rose to record levels last year and might easily rise again. Even so, they’re relatively rare. Downgrades are more common, and that’s what you have to worry about, says Baird’s chief investment officer, Mary Ellen Stanek.

Weak Underpinnings

When a credit rating firm cuts an A-rated bond to A-minus or BBB, its market price plunges. That affects similar bonds that are still rated A but whose underpinnings are weak. The downgraded bond continues to pay its fixed rate of interest but if you have to sell it, you’ll take a loss. If the rating drops below BBB-minus, which is the lowest investment grade, the price drops even more.

Downgrades are just starting to pour into the muni market. States, having run through their rainy-day funds, are slashing subsidies to towns and cities, which are already struggling with reduced sales- and property-tax collections. Some 48 states face fiscal stress, the Center on Budget and Policy Priorities reports, a situation that’s likely to continue for the next two years.

Standard & Poor’s Ratings Services downgraded 327 municipal issues in the first quarter alone, already exceeding the total of 264 for all of 2008. Illinois dropped to AA-minus from AA. Rhode Island (AA) and Florida (AAA) are on negative credit watch.

Notorious at Reporting

And who believes that the ratings firms are up-to-date on fiscal stress or even have enough information to issue grades? Municipalities aren’t bound by the same financial disclosure rules as corporations, and are notoriously poor at revealing negative information.

When you think about income investing today, what’s your priority?

If income is primary, look for a mutual fund that buys at least some lower-rated issues, Fabian says. Consider quality funds that tip toward the lower end of the investment-grade range -- bonds rated A and BBB. They provide slightly higher income at less risk than you’d get in a high-yield fund.

He also suggests that you allocate 20 percent of your bond money to high-yield funds. They paid an average of 6.2 percent over the past 12 months, Morningstar reports, compared with 4.2 percent for higher-quality funds.

Live With Volatility

You have to be able to live with their volatility. High- yielders are up 15.6 percent in price since the start of the year. In a poorer market, they could drop 20 percent or more. Assuming that you can overlook that little point, you’ll reap a higher income, over the years, than if you had stayed in higher- quality funds.

The trouble is, you might not stick for many years. You might run scared when your fund’s value drops. (Nuveen’s High Yield Municipal Bond Fund lost 40.5 percent in 2008.) Or you might need the money and have to sell.

In total return -- that’s interest plus principal -- high- yield funds have lagged higher-quality funds for the past one, three, five and 10 years, Morningstar reports. They put more current income in your pocket but take some of it back when you cash in.

Intermediate or Long

Quality bond funds are the right choice for people who want liquidity as well as income. Pierson favors intermediate-term over long-term bonds. They give you the lion’s share of the value while reducing the risk. He buys general obligation bonds, revenue bonds that are backed by essential services such as water and sewer, and pre-refunded bonds, which are effectively backed by Treasury securities. To juice the income a bit, he looks for downgraded bonds that are still good credits.

National funds, which can buy the bonds of any state, provide better diversification than single-state funds. Today, they’re picking up bonds from the weaker states, which pay higher interest but aren’t likely to default. The trade-off: You may owe state taxes on the income. Your own state’s bonds are tax exempt.

Buying individual bonds is always a question. Retail investors pay more than institutions do and take a haircut in price if they find, unexpectedly, that they have to sell before maturity. Bond ladders work, but keep them short-term, says financial planner Jonathan Krasney of Krasney Financial in Mendham, New Jersey. You take your risk on the equity side. The fixed-income side is where you play it safe.

(Jane Bryant Quinn, a leading personal-finance writer and author of “Smart and Simple Financial Strategies for Busy People,” is a Bloomberg News columnist. She is a director of Bloomberg LP, parent of Bloomberg News. The opinions expressed are her own.)

To contact the writer of this column: Jane Bryant Quinn in New York at jbquinn@bloomberg.net

Last Updated: July 1, 2009 00:01 EDT