After being asked (well, forced) by Congress recently to testify regarding the credit rating agencies Moody’s and Standard & Poor’s and their role in the last financial crisis, Warren Buffett was also asked what he saw the next big related risk. Buffett’s reply:
Well, the huge question … if I were running a rating agency now, how would I rate states and major municipalities? I mean, if the federal government will step in to help them, they’re triple-A. If the federal government won’t step in to help them, who knows what they are? If you are looking now at something where you could look back later on and say, these ratings were crazy, that would be the area.
“I don’t think Moody’s or Standard & Poor’s or I can come up with anything terribly insightful about the question of state and municipal finance five or 10 years from now except for the fact there will be a terrible problem and then the question becomes will the federal government [help]
It’s no question that many states and municipalities are in big financial trouble. But their municipal bond debt still has relatively low interest rates suggesting that the risk of default is very, very small. No doubt, this is because the historical default rate of municipal bonds is also very, very small. But Buffett points out that in the past, not very many muni bonds were insured by private insurers (such as Berkshire Hathaway). In today’s environment, it is much more likely that a local government will go “oops” and let the insurers pick up the tab. If those dominoes start falling, then a federal bailout will be needed. Then what?
As usual, Buffett summarizes the situation nicely:
“It would be hard in the end for the federal government to turn away a state having extreme financial difficulty when they’ve gone to General Motors and other entities and saved them,” Buffett told shareholders in Omaha, Nebraska, at Berkshire’s May 1 annual meeting. “I don’t know how you would tell a state you’re going to stiff-arm them with all the bailouts of corporations.”
When I wrote about investing in California municipal bonds in September 2009, the yield on the Vanguard California Intermediate-Term Tax-Exempt Fund (VCAIX) was 3.49% and exempt of both federal and CA state income taxes (avg maturity 7 years). Today, it is down to 3.02% with an average maturity of 6 years, indicating a lower overall fear of default.
Still, if you are in the 33% federal tax bracket and 9.55% CA bracket, that 3.49% would be the same as a taxable bond yielding 4.98%. Compare this to the Vanguard Intermediate-Term Investment-Grade Fund (VFICX) which invests in high-quality corporate bonds and only yields 3.70%. Treasuries yields are much lower. For me, the yield difference is so great that it would be hard to not at least consider it as part of my portfolio.
I agree that I can’t see how the federal government will refuse to help bail out the resident investors of states when they’ve already done so many corporate bailouts. But it’s not impossible.
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