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Warren Buffett is Dumping Munis – Should You Care?

24 August 2012 in Trading Ideas

It’s hardly news that it’s big news whenever a trade by famed investor Warren Buffett makes its way into public discourse. The public filings of his company, Berkshire Hathaway (BRKB), are sifted through routinely as if the secrets to long-term wealth can be discerned from within.

And now comes the news that the Oracle of Omaha has raised the proverbial red flag to mere mortal investors by ending a large wager on the municipal bond market. Specifically, Berkshire announced earlier this week that it terminated so-called credit default swaps that insured $8.25 billion of municipal debt.

In effect, Berkshire sold insurance that would require the company to pay out in the event of bond defaults. These contracts were bought by Lehman Brothers in 2007 and essentially were a bet by Buffett before the financial crisis that more than a dozen of the states insured by the contract would continue to pay their bills on time.

Berkshire continues to hold other credit-default swaps, but the fact that the company is now trimming its stake has begun to force other investors to wonder whether they should do the same.  As hedge-fund manager and Buffett-follower Jeff Matthews told the Wall Street Journal  in an article published on Tuesday, Buffett probably “doesn’t want this exposure anymore and is getting out while he can.”

While the muni bond market appears to be in flux, its future canbe described as “anyone’s guess.” The fact remains that past predictions of massive defaults by municipalities have yet to come to pass, which has contributed to the post-financial crisis rally in munis. And, as the Journal notes, the S&P National AMT-Free Municipal Bond index, a broad measure of highly rated bonds, is up 4.9% year to date.

On the other hand, the level of anxiety has been raised by three recent bankruptcy filings in California and growing fears by some investors, according to the Journal, that stressed municipalities may consider reversing the historical trend and begin favoring taxpayers rather than bondholders.

However, a recent Smart Money article suggests investors do run the risk of reading too much into Berkshire’s recent muni move. As Matt Fabian, managing director of research firm Municipal Market Advisors, told  Smart Money, “Buffett’s decision may say more about the waning interest in such insurance contracts than in the credit quality of the underlying bonds. If fewer people want to make these kinds of bets, investors like Buffett could lose money, regardless of whether bonds default.”