The debate on the wisdom of investing in municipal bonds continues. Meredith Whitney and many retail investors are worried about widespread defaults.
Bill Gross and a vast army of analytically disposed investors think concerns are overdone. For our part, as we’ve said before, while widespread defaults are unlikely, the risk return doesn’t appear that compelling in munis for the time being.
Rising interest rates will provide a headwind against sharp gains for those value-seeking investors willing to invest at today’s lower prices, so the limited upside possible from being right about defaults makes the sector broadly unattractive.
Many analysts are suggesting that muni investors should stick to high quality issues backed by states with sound finances. They further note that basic credit analysis will increasingly be a requirement for every muni investor. That prospect alone should justify higher yields – if relying on rating agencies is no longer sufficient before buying state and local government debt, then the yields ought to be higher to justify the extra work.
Insurance companies are the largest holders of municipal bonds after individuals. They are presumably well situated to do credit analysis, since insurance companies typically hold large portfolios of bonds of all kinds.
They are just the type of sophisticated, value seeking investor that you might imagine would be buying up munis today. However, a review of recent quarterly earnings reports reveals that at least two insurers (Allstate and CNA) were steadily reducing their holdings of munis all of last year and this continued into the fourth quarter.
Minicipal Bond Holdings Analysis
2010 Muni Holdings
2009 Muni Holdings
% of Investments
% of Investments
Source: Company Reports
What’s fascinating is that these are the actions of unbiased participants with the capability to carry out the detailed credit analysis that muni proponents increasingly concede is required of every investor. Allstate and CNA have no investment in the business of munis, they are simply looking for acceptable returns on their assets. Presumably they regard they risk/return as justifying somewhat less exposure, even while yields have been rising.
Author has no positions in the stocks mentioned
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