By Jonnelle Marte
With Warren Buffett apparently cooling on municipal bonds, mere mortal investors are wondering if they should do the same.
Investing pros – muni fans included – agree the credit risks in the market are rising. But Buffett’s recent decision to back off a long-term wager on bonds has some fearing more defaults could be imminent. A Fitch Ratings report released Monday says municipal bond downgrades should continue to outpace upgrades for the next year or two. And more municipalities are facing “superdowngrades”– getting their credit ratings lowered by three or more notches. Certain states, such as California, where legislators are limited in how much they can raise property taxes, could be harder hit than others, according to the report. And with revenue from sale and property taxes shrinking, some local governments are struggling to make good on their debts, says Jessalynn Moro, head of the U.S. local government group for Fitch Ratings. “There’s definitely greater stress than there has been in the past,” says Moro. And the problem is most “acute in those areas where budget flexibility is limited,” she says.
But Buffett aside, experts say muni investors can minimize the risks by being more selective. Brian Kazanchy, a wealth manager for RegentAtlantic Capital in Morristown, N.J., prefers high-quality general obligation bonds to riskier revenue bonds, which are more likely to default. “Investors in general — and Warren Buffett is no exception — are seeing that the situation has gotten worse in a lot of areas in the country,” says Kazanchy, who reduced his use of munis to about 15% of a bond portfolio, down from roughly 60% several years ago. Indeed, the biggest bond defaults come from revenue bonds used to fund large, risky projects like nuclear power plants or football stadiums, analysts say. Defaults are also mainly constrained to small, unrated bonds, which are most likely to be found in high-yield municipal bond funds that invest in riskier munis, says Matt Fabian, managing director for Municipal Market Advisors, a research firm.
In fact, it may be unwise to read too much into Buffett’s move about the state of muni bonds, pros say. His decision to stop using credit default swaps to back munis, which would require him to pay up if a bond defaulted, could have more to do with waning interest in such insurance contracts than with the credit quality of the muni bonds themselves, says Fabian. Investors like Buffett could lose money if fewer people are willing to make those kinds of wagers, whether or not bonds default, he says. And interest in municipal bonds has not exactly dried up: Municipal bond funds collected $900 million in the week ended Aug. 15, marking 18 straight weeks of inflows, according to fund research firm Lipper.
But that interest has created another problem for municipal bond investors: record low yields – especially on the safest bonds. Triple-A-rated 10-year municipal bonds yield about 1.9%, down from 3.2% at the start of 2011. Those lower yields mean the bonds have lower return potential going forward, experts say. It is also a sign that some investors who are willing to take on credit risk in the market may not be fully compensated, says Kazanchy.