Recently, Buffett’s Berkshire Hathaway cut its exposure to the municipal bond insurance market. Berkshire Hathaway previously insured billions of dollars of municipal bonds against default. In the event a municipality couldn’t repay its obligations, Buffett’s firm would step in to make good on payouts.
The business of default insurance is huge, and wildly profitable so long as municipalities continue to make good on their obligations.
Should You Own Municipal Bonds
Investors see Buffett’s exit as a sign that the municipal bond market may not be as strong as it once was. Municipalities face revenue problems stemming from an inability to increase taxes, and concerns over whether such investments like toll roads or stadiums can create sufficient new income to repay borrowers.
In most cases, investors get very little from the municipal bond market. Because municipal bonds are not taxed by the Federal government, munis are priced for the super-wealthy. To put it simply, unless you’re in the top 1% of income earners, you earn a post-tax return in municipal bonds that does not justify the risk. Those who do not earn enough to be in the upper tier of Federal tax brackets should shop elsewhere – post-tax returns will be much higher on a risk-to-reward basis.
But let’s assume that you are in the top 1% of income earners and your last marginal dollar does fall into the highest of tax brackets. Let’s look at a few concerns investors should have with municipal bonds:
- Inflation Risk – Inflation is a very real concern. Currently, municipal bonds rated AAA by the three ratings agencies yield only 1.7% for 10 years. The rate drops to 0.76% for bonds held for a 5 year maturity period. Municipal bonds will likely only protect your purchasing power, not grow it, going forward. (Data from Yahoo’s bond rate tables.)
- Pension Risk – Municipalities have a record amount of pension obligations over the next several decades. Several cities have turned to the municipal bond market to raise money for the express purpose of making good on their obligations to retired workers. Recently, Stockton, California reported that its pension obligation bonds will put the city underwater. The municipality now plans to proceed through bankruptcy, wiping away investors’ capital in the process.
- Housing Risk – Municipal bonds are, in many ways, just another bet on housing. Municipalities thrive on local property taxes, which can be used to fund general obligation bonds that are drawn on the general accounts of a small city. When housing prices fall – and stay near their historic bottoms – cities have to push through unpopular property tax hikes to make up for anticipated increases in housing prices. When housing was hot, property tax income grew year after year as homes had a higher taxable value. Today, housing tests lows in all but a few brand name locales each month.
Real Estate over Municipal Bonds
The best municipal bonds are general obligation bonds, which are the least likely to experience a default. But general obligation bonds are mostly tied to real estate prices, and yet provide very low yields to investors.
Personally, I see a REIT or direct investment in real estate to be a much better wager than a sizeable position in a municipal bond fund. The reality is that while municipalities live and die on real estate prices, investors are not paid enough for their exposure to real estate. Skip the middleman – the municipality – and look at an ETF like FTSE NAREIT Residential Index (FEZ), which tracks the residential, health care, and self-storage REITs on the market. The fund’s somewhat erratic dividends total to more than 3% per year. Upside potential remains in a true housing recovery.
If you’re going to bet on real estate, you might as well be compensated for risk. Municipal bonds are the poorest yielding way to make a wager on housing prices. Just take the real estate by itself – it pays more.
What are your thoughts on municipal bonds?