Private Advisory Group

No Quick Turnaround

Posted by Steve

The relative security of municipal credit, long seen as a more sound investment than corporate bonds, has been bolstered by the fact that bond investors strictly avoid future investing in a town that defaults on their municipal debt. If the town ever wants to raise money again, it can be very hard and very expensive to do so after a default, and so municipal bonds have been perceived as relatively sound.

There is an understandable lag between the time that economic distress in the communities shows up in municipal finances, and financial advisers and investors have recently begun to see that these once stable investments are starting to look a little shaky. For individual investors, it can be hard to know when a municipal bond is in jeopardy. You have to look pretty hard to find that interest payments are going unpaid. When it finally becomes newsworthy as we’ve all seen the recent media headlines announcing a variety of government-issued bonds, both foreign and at home, it happens when the bond is nearing bankruptcy or default status.

As real estate values steadily plummet and high unemployment continues to rob cities of their tax revenue base, a number of municipalities are starting to renege on their debts. Since July one year ago, 201 municipal bond issuers have missed their interest payments – up from 162 in 2008 and a significant increase from 31 in 2007. While at least some of these failing bonds are not of the caliber most investors want to buy, their failure is still enough to inspire second thoughts among experienced financial professionals.

Municipal bonds can lose value even without a default. In fact, according to Bloomberg (June 2, 2010), Warren Buffett, whose Berkshire Hathaway Inc. has been trimming its investment in municipal debt, predicted a “terrible problem” for the bonds in coming years.

“There will be a terrible problem and then the question becomes will the federal government help,” Buffett, 79, said today at a hearing of the U.S. Financial Crisis Inquiry Commission in New York. “I don’t know how I would rate them myself. It’s a bet on how the federal government will act over time.”

If a city or town faces financial difficulties, as so many are now, buyers won’t pay as much for its debt. According to Barclays, nearly 13 percent of municipal bonds that are currently active are trading at less than their face value – this is up from 7 percent before the recession. Rising interest rates can also hurt ‘muni’ bonds, and many believe interest rate increases are coming. While falling prices aren’t a huge problem for investors who hold their bonds until their maturity, those who need to sell a bond may experience an unfortunate loss if prices stay depressed. While no one is predicting a total municipal bond crash the likes of which we’ve seen with the stock market, all of these signs are good reason to pause before investing.