When Warren Buffett takes action, investors should take notice.
Last month, the Oracle of Omaha, the world’s greatest investor, closed out a large bet on the municipal bond market.
The Wall Street Journal reported that his company, Berkshire Hathaway, terminated agreements to insure $8.25 billion in municipal debts. The credit default swaps were a bet that more than a dozen U.S. states would keep paying their bills on time.
Canceling those agreements indicates that Buffett “doesn’t want this exposure anymore and is getting out while he can,” a hedge fund manager said.
Buffett’s move is a warning to municipal bond investors to proceed with caution, but it doesn’t appear they are doing so. Investors are pouring billions of dollars into mutual funds that buy municipal bonds.
Municipal bonds are debt securities issued by states, cities and other local government entities to raise money for public purposes. Investors who buy municipal bonds are lending money to a state or local government.
California residents who buy bonds within the state receive interest that in most cases is exempt from both federal and state taxes.
Tax-free interest is appealing. And historically, defaults by municipalities have been rare.
But Buffett’s move calls into question the image that municipal bonds are absolutely safe. A weak economy, falling property-tax revenue and rising pension and health-care costs for public employees have squeezed city and state budgets.
Three California cities filed for bankruptcy this year: San Bernardino, Mammoth Falls and Stockton, the biggest U.S. city ever to go broke. More than 10 percent of California cities have declared fiscal crises, according to the bond rating agency Moody's.
Despite this, the continued popularity of municipal bonds has kept borrowing costs down for most California cities. But that could change. If investors begin to follow Buffett’s lead and pull out of municipals, prices for the bonds would fall and interest rates would rise.
Even Californians who don’t own municipal bonds could feel the effects. A worsening financial picture for cities could force them to reduce city services or raise local taxes and fees.
How would Scotts Valley be affected if municipal bond prices fall and their interest rates rise?
City Councilman Jim Reed said the city has been taking advantage of the recent low rates to refinance much of its debt.
“If rates were to rise sharply, the city won't be impacted much at all,” he said, “because we won't be taking on new debt anytime soon, and our old debt is locked in at favorable rates.”
Reed said the city’s frugal ways mean it won’t need to raise taxes or cut services for several years at least.
Meanwhile, the city of Santa Cruz is proposing a tax increase on lodging, its sixth attempted tax hike in the past decade, Reed said. He added that more California cities are considering bankruptcy than the three that filed this year.
An August report by Fitch Ratings anticipates an increase in defaults by municipalities beyond the three that have already filed for bankruptcy, while Moody’s started a review of city finances in California because it sees a growing threat of cities going bankrupt or defaulting on loans.
More bankruptcies by cities would send municipal bond prices lower. Buying them against that backdrop may prove costly and may prove once again that investors who ignore Buffett do so at their peril.
- Mark Rosenberg is an investment consultant for Financial West Group in Scotts Valley, a member of FINRA and SIPC. He can be reached at 439-9910 or firstname.lastname@example.org.