Muni Bonds: Time To Get Worried?

Some of our clients are calling to talk to us about what’s happening in the municipal bond market.  They read that Warren Buffett’s company Berkshire Hathaway terminated contracts it had written insuring $8 billion of  municipal debt. Does this mean, they ask, that Mr. Buffett is souring on the muni bond market?

The short answer is no.

As background, Berkshire sold these insurance contracts to Lehman Brothers back in 2007.  By insuring the bonds against default, they agreed to pay Lehman if the bonds in question went bad at any time over the next 10 years. The contract is being terminated early as part of the Lehman bankruptcy liquidation, allowing Berkshire to exit earlier than anticipated.  None of the bonds in the deal has defaulted, according to one report, so Berkshire is likely pocketing the $162 million premium payment it received.

So let’s sort out what this means.

Buffett is not saying he doesn’t like muni bonds.  He is saying he doesn’t want to keep insuring them at a price negotiated in 2007. According to the Wall Street Journal, “the cost of insuring the states from default …  is now much higher than in 2007.”

To keep those old contracts in place would be like an insurance company in Florida offering to insure your house at pre-hurricane Andrew prices.  Not going to happen (we only wish).  Besides, Buffett still has outstanding another reported $8 billion in muni insurance contracts, so he is far from exiting the market entirely.  Just because Buffett is cutting back his business of insuring muni bonds doesn’t mean he’s down on investing in muni bonds, according to the muni experts we’ve heard from.  (In fact, independent reports say Berkshire holds almost $3 billion worth of munis in its own portfolio.)

The muni market is vast and predominantly high quality.   This is a $3.7 trillion market composed of a staggering 80,000 municipal entities and 55,000 different bond issuers.  In that enormous market, Moody’s Investors Service counts only 71 defaults since 1970, making the default rate on investment grade muni bonds less than 1/10 of 1%.

Muni defaults actually decreased in 2011, according to Morningstar analysts, who say “many state and local governments have taken steps to close budget gaps through some combination of hiking revenues and spending cuts.”

Nonetheless, state and municipal finances do remain under stress, which is why it’s important to use the services of experienced muni bond managers who carefully weigh the credit quality of various issuers and make informed and prudent bond selections.

Munis are still a great choice for many investors.  Muni bonds have performed very well and we expect strong demand for munis going forward, given the prospect of tax hikes on the horizon.  That said, due to strong performance this year, muni prices are now higher and yields lower than before (which, as all savvy investors know, makes them less attractive investments going forward). Still, that package of high quality and tax-free income is hard to resist.

Making portfolio decisions based on rumors is almost always unwise.  Investors who panicked after Meredith Whitney’s misguided December 2010 “sell” call on munis lost out on an excellent investment opportunity. After the Buffett article appeared, we took part in a number of discussions with highly respected portfolio managers, bond experts, and wealth strategists about their views on the muni market.  While all are watching market developments with a careful eye, not one endorses running for the exits.  In fact, the consensus view is that municipalities continue to make progress on addressing budget imbalances, and despite problems, there are plenty of opportunities to go around.

 

 

About Mari Adam

Mari Adam, Certified Financial Planner™ and President of Adam Financial Associates Inc, has been helping individuals and families chart their financial futures for over twenty-five years. Have a question about your financial situation? Ask Mari!
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