Updating the Tax-Exempt Bond Market

The tax-exempt bond market continues to attract headlines and raises concerns among investors. Investors have been on edge since Meredith Whitney’s late-2010 remarks that quite a few tax-exempt bond defaults were on the way. Since then there have been a few high-profile bankruptcy filings by municipalities, but the cascade of defaults some were expecting hasn’t occurred.

Here are the latest events you need to know.

The Federal Reserve issued a report on tax-exempt bonds which had two significant conclusions. One conclusion is that the default rate on tax-exempts is considerably higher than most investors realize, but it still isn’t very high. Another conclusion is that tax-exempts still are safe investments because most of the defaults are on unrated bonds and focused in sectors, such as industrial development bonds.

The other event is that Warren Buffett and Berkshire Hathaway apparently have backed away from insuring tax-exempt bonds. The firm’s insurance subsidiaries entered the market in a big way a few years ago, believing default risk was low and easy money was to be made. The Wall Street Journal reports that Berkshire quietly terminated its insurance on the bonds. There aren’t any details such as whether it paid to terminate the insurance or had a profit or loss on the deals. But the Journal is reporting this change as Buffett’s being worried about the ability of the governments to pay their debts over the next five years.

To arrive at that figure, the Fed includes defaults on unrated debt, which are far more numerous. There’s a reason such defaults aren’t usually counted by ratings companies. Municipalities that don’t seek ratings for their debt are almost axiomatically less creditworthy than those that do. That’s why the average investor is much less likely to be exposed to them.

Further, the most common type of defaults the Fed found were for industrial-development bonds, which governments issue on behalf of private companies — and which usually aren’t backed by taxpayers. Vast defaults on government debt, in other words, aren’t somehow being covered up by ratings companies — and Whitney’s default apocalypse is as improbable as ever.