Muni Defaults: Buffett's Warning Is Loud and Clear

Message received loud and clear, Warren. In a move that should give genuine concern to investors in U.S. municipal bonds, Warren Buffett's Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) has terminated insurance contracts it sold against default on $8.25 billion in state and municipal debt -- half the total exposure it was carrying at the end of June. But that's not half of the story.

Did Buffett eat a loss?
Indeed, given a free hand, Berkshire might have eliminated its exposure altogether; alas, according to its most recent quarterly report, the remaining contracts do not permit termination prior to the maturity of the underlying obligations, which ranges from 2012 to 2054. Worse still, it appears that Berkshire may have been willing to eat a loss on the contracts in order to close them out. According to The Wall Street Journal, Berkshire originally sold the insurance on $8.25 billion in bonds from 14 states, including Texas, Florida, California, and Illinois, in 2007. As the Journal story explains: "[The] cost of insuring the states from default, however, is now much higher than in 2007, according to data provider Markit."

Whether or not they ultimately come to the same conclusion as Buffett, investors who own a muni mutual fund or ETF such as the iShares S&P National AMT-Free Municipal Bond Fund (NYSE: MUB  ) or the SPDR Barclays Capital Municipal Bond ETF (NYSE: TFI  ) are well advised to reassess their exposure.

Explain this to me like I'm a four-year-old
As far as I'm concerned, the economics of investing muni bonds don't add up. U.S. Treasuries offer a pitiable return; take the two-year Treasury note, which offers investors all of 29 basis points in annual yield (100 basis points equal one percentage point). That's not an investment, it's a hunger strike, and I can't refrain from questioning the sanity of investors making that choice. With that in mind, what then are we to make of municipal bond investors who are willing to swap the default risk of the U.S. federal government for that of states and municipalities to pick up 14 basis points in taxable equivalent yield? If you're resigned to starving yourself, I don't see the point in fiddling with a set rat trap to obtain a single grain of corn.

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Fool contributor Alex Dumortier holds no position in any company mentioned. Click hereto see his holdings and a short bio; you can follow him @longrunreturns. The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (6) | Recommend This Article (19)

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  • Report this Comment On August 22, 2012, at 2:35 PM, pondee619 wrote:

    " take the two-year Treasury note, which offers investors all of 29 basis points in annual yield"

    "who are willing to swap the default risk of the U.S. federal government for that of states and municipalities to pick up 14 basis points in taxable equivalent yield" or .43% per year?

    But doesn't MUB have an annual yield of 3.04% and TFI 3.02? My Nuveen NQJ is paying

    a 5.35% yield. All a fair cry from .43%, No?

  • Report this Comment On August 23, 2012, at 12:07 PM, jc09058 wrote:

    I'm not surprised the default insurance contracts are being terminated early. About a year ago, the first rumblings about cities going bankrupt (yes, there was talk before but not like it has become), I've been expecting things to get worse. With four California cities currently exploring bankruptcy, I have to wonder how many others out there are ready to join them.

    I keep reading about rising taxes at city and county levels but I'm wondering if that is just a finger in the rupturing dike or not. As it is, i don't see investing in muni's over the next few years. In fact, any government financial instrument is a questionable investment at this time and will remain that way for while longer.

  • Report this Comment On August 24, 2012, at 1:20 PM, Mega wrote:

    "As far as I'm concerned, the economics of investing muni bonds don't add up."

    The economics of investing in jet skis doesn't add up either, but GEICO still insures them.

    Investing in muni bonds and insuring them are two different issues.

  • Report this Comment On August 24, 2012, at 2:23 PM, whyaduck1128 wrote:

    It is Known Fact, indisputable and immutable, forevver and ever, amen, that The Oracle has never ever been wrong about anything. He's probably right this time, as he's right more often than not, but let's not fall into the usual Fool trap of assuming that "If Warren says it, it must be so."

    For the record, I have no dog in this fight. I own no municipals and sold my BRK earlier this year.

  • Report this Comment On August 24, 2012, at 2:23 PM, whyaduck1128 wrote:

    *forever

    I'm such a lousy typist.

  • Report this Comment On August 25, 2012, at 10:56 AM, 4farme55 wrote:

    I can't make sense of the numbers used in Dumortier's article. Like PONDEE619 commented, my Calif. bonds yield about 5.24% double tax free. (Granted, they are all long term.)

    Don't get me wrong. I'm not proud of them, but, I certainly would not consider owning them at the 0.43% yield mentioned in the article.

    I'm walking on eggs with these bonds, but IMHO, no more so than with my Aflac, Westport, etc.

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