Warren Buffett's offer to stand behind municipal bond payments is like offering auto insurance to a driver with a perfect record. Municipal bonds, or munis, are one of largest and safest corners of the bond market. There are about $1.7 trillion worth of such bonds outstanding, says the Securities Industry and Financial Markets Association. Munis are sold mainly by state and local governments to pay for projects such as roads, schools and hospitals. Munis are popular with high-income investors because the payments are often tax-exempt. But they're also relatively safe. If a city gets into financial trouble, it can charge higher taxes, close libraries or parks. There have been some high-profile muni bond debacles, including Orange County in the 1990s. Still, only about one muni bond a year, on average, has gone into default over the past 40 years, says Bill Larkin, a bond investor at Cabot Money Management. Less than 0.25% of muni bonds historically go into default, says Michael Decker at SIFMA. There are 2 million munis outstanding. Excluding riskier muni bonds issued for special purposes in partnership with outside companies, such as some toll road projects, the muni default rate is essentially zero, Decker says. Compare that with the 35,000 business bankruptcy filings each year on average this decade, according to BankruptcyData.com. Buffett may not be taking a giant risk in offering insurance to the three main insurers that stand behind muni payments. Even so, the offer exposes vulnerabilities in the muni market, including: •Stress on some lower-rated munis. Thanks to their relative safety and preferred tax status, cities and states can borrow inexpensively: Muni bonds are yielding roughly 3.4% for a bond maturing in 10 years, S&P says. That's even cheaper than the 3.78% 10-year Treasury yield. But where there is some strain is among munis issued by government-backed entities with low credit ratings, Larkin says. Most professional investors will only buy these m unis if they are guaranteed by insurers like MBIA, Ambac Financial and Financial Guaranty Insurance. That guarantee may give a lower-rated muni a AA or higher rating. But the insurers also guaranteed some mortgage loans. If the insurers are hit with an avalanche of mortgage claims, investors worry there may not be enough left to back the insured munis. Consider a San Jose, Calif., redevelopment muni that matures in 2028, Larkin says. The muni is yielding 5.04%, despite being insured, because investors doubt the insurance has any value. •Potential for a ripple effect. If the insurers backing the riskier munis lose their top credit ratings, the riskier munis themselves will lose their high ratings, too. That could cause investors who can only own highly rated munis to sell some of the riskier munis, setting off a selling spree. "My biggest concern is with the insured muni bonds," says Bill Hornbarger, bond strategist at A.G. Edwards. •Exposure to recession. States and cities may come un der pressure as the economy slows. At least 20 states are facing spending cutbacks, says Allen Sinai of Decision Economics. Local governments that counted on rising tax receipts due to rising property values now have budget shortfalls, says Dean Baker of the Center for Economic and Policy Research. Having Buffett ready to cover losses will reassure investors there is a safety net in the market, he says. That would be critical if the slowdown causes more cities to struggle. "It's hard to believe we're not going to have more (muni defaults) than that would normally be the case," Baker says.
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Municipal bonds by the numbers
$1.7 trillion
value owned by investors
$11 billion
daily trading volume
5.1 million
households that own them directly or indirectly
50,000
state and local governments that sell them
Source: The Securities Industry and Financial Markets Association
(c) USA TODAY, 2008
