How safe are your municipal bonds?
February 20, 2012
by Brian Wolf

“Superdowngrades could sink municipal bonds.” This was the front page headline that appeared in Investment News Feb. 6 2012.

Ever since 2008 there have been cries that the sky is falling on municipal bonds and so far, although it’s rained a little, the torrential downpour of defaults just hasn’t happened as some predicted. The reason that this topic doesn’t just go away is because there is still a tremendous amount of pressure on our municipal bonds. This column contains excerpts from the Investment News article written by Jason Kephart.

A dramatic increase in the number of “superdowngrades” could wallop the municipal bond market this year, muni experts predict.

They believe that the number of such double or triple-tier declines in credit ratings could jump from the typical one or two per year to dozens as ratings agencies comply with Dodd-Frank’s demands for more-intense scrutiny of issuers and as municipal bond insurance becomes less common.

Before the financial crisis, nearly half of all municipal bonds were insured. Now, because the price of such insurance has soared, only about 6 to 10 percent of municipal bonds are insured, said Patrick Early, chief municipal bond analyst at Wells Fargo Advisors. Absent insurers’ guarantees, ratings agencies now must vet issuers more diligently, and they’re playing catch-up, he said. “It really underscores that you need to know what you own,” said Tao Chen, vice president and municipal bond strategist at investment manager Payden & Rygel.

Peter Hayes, head of municipals at Black-Rock Inc., told attendees at an Investment Management Consultants Association conference in New York last week that the frequency of muni audits is getting more attention, as well as financial disclosure. Superdowngrades could be particularly harmful to portfolio values, Mr. Hayes stated.

He pointed to the recent experience of DeKalb County, GA, the rating for which slid from AA+ to BBB.

The decline forced the county to pay an extra 80 basis points on its debt, which slashed the value of its outstanding lower-coupon bonds.

Ramesh Gulati, principal at Gulati Asset Management LLC, said that he is reducing his clients’ muni bond exposure, especially on the local level, where he expects defaults to pick up.

Because there are many kinds of municipal bonds, you need to ask yourself not only are my municipal bonds safe, but exactly what kind of municipal bonds do I own? As you may already know, there are people on both sides of the fence on this issue. But you can add investment legend Warren Buffett to the list of those who warn of a municipal debt meltdown. According to Buffet “Many municipalities have promised overly generous retirement and health benefits to public workers without any viable plans to bring in the money necessary to pay for those benefits. They have assumed unrealistic returns in their pension fund investments and unrealistic revenue from taxes. There will be a terrible problem, and then the question becomes, will the federal government help? I don’t know how I would rate them myself. It’s a bet on how the federal government will act over time.” Buffett said this at a hearing of the US Financial Crisis Inquiry Commission in New York, Bloomberg reported.

Buffett has made clear his bearishness toward municipal bonds by warning of the dangers of insuring those bonds. Even though he is the most successful investor in America, and widely respected for his views, it’s worth noting that he’s not always right.

It seems like the issue of safe bonds will always come back to, what’s the bond being used for and who’s going to back it? And, of course, if the government is involved, you may want to step back and really think about how that might end up.

The real answer is that nobody knows how safe your bonds are. Like with most investments, “buyers beware” is a good place to start the conversation. Also, keep in mind that a really good financial planner should have many other options for any money you can’t afford to lose.

Since we are in tax season right now, I’ll end this column with a little tax humor. A couple of weeks after hearing a sermon on Psalms 51:2-4 (knowing my own hidden secrets) and Psalm 52:3-4 (lies and deceit), a man wrote the following letter to the IRS:

“I have been unable to sleep, knowing that I have cheated on my income tax. I understated my taxable income last year, so I’ve now enclosed a check for $150.If I still can’t sleep, I will send the rest.”

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