Bogue's Blog

For those who invest in municipal bonds, or for that matter are receiving a pension or expect to receive a pension from a municipality, you should pay attention what Warren Buffett has to say.

On Wednesday, Warren Buffett said at a hearing of the U.S Financial Crisis Inquiry Commission in New York said that there will be a “terrible problem” for municipal bonds and said, “Then the question becomes will the federal government help.”

There is no question that local governments are under pressure as the financial crisis lowered revenues that they receive in the form of income, real estate and sales taxes. Further compounding matters, many pension plans are underfunded due to the market losses suffered a few years ago coupled with the rosy return projections and lower funding that came beforehand. Yes, from a prohibitive perspective this can create a vicious cycle and quickly become a contagion similar to the fall of 2008.

What should you do? Now for those who are currently receiving a pension, the odds are quite low that your benefits will be reduced. But I wouldn’t make the assumption that they are perfectly safe either. For the current worker that expects to receive a pension in the future, I wouldn’t hang your retirement hat solely on your pension. I believe the same would be said of people solely relying on Social Security.

For people who invest in municipal bonds, I’d be very careful. Regardless of the potential risk addressed above, I’m not a big believer in buying individual muni bonds as for most people the dollar amount needed to buy an individual bond makes it very hard to diversify the risk. Unless you directly buy from the issuer, brokers make an awful lot of money on the spreads as muni’s are very thinly traded, which eats away at your yield. This lack of liquidity also makes it more difficult to sell an individual muni at a favorable price. If you do purchase municipals, it is best advised to use mutual funds to accomplish this; in particular funds that only buy bonds with high credit ratings. If you must buy individual muni bonds, focus on the one’s that are backed by the taxing authority of the entity rather than revenue bonds, which repayment is backed on a specific project. Because of this project risk, these types of bonds are more likely to default than ones that have the ability to tax to pay back the debt. If you are at risk of paying the Alternative Minimum Tax (AMT), you want to stick to funds or bonds that generate little private activity interest as this is an exception item for the AMT.

Finally, there are some scenarios where you should never buy municipals. It’s simply a waste of time to buy municipals in an IRA as the tax benefits are lost. And you really don’t get much benefit if you are in a low tax bracket.

In the end, just keep in mind that the risk of municipal default is quite real. And I wouldn’t bet against what Warren Buffett has to say.