by John Darer® CLU ChFC CSSC RSP
Structured settlements and municipal bonds both offer income to payees that is tax exempt**. While a plaintiff may be getting the heavy sales pitch from a financial planner about investing in municipal bonds or municipal bond funds as an alternative to structured settlements, how do the risks compare between structured settlements and municipal bonds?
Following is chronological collection of media concerning municipal bonds stretching back to the Spring of 2009, when Warren Buffett began to express his doubts:
"The Oracle of Omaha is voicing concerns about the ability of some battered local and state governments to pay off their debts. The idea of cities and states facing insolvency is alarming for sure, and Buffett isn’t alone. Moody’s recently assigned a “negative outlook” to the creditworthiness of all the nation’s local governments. The agency has rarely made such a sweeping generalization but said the magnitude of this recession warranted the move". from Smart Money April 23, 2009 "Will Municipal Bonds Really Default"
"Municipal bonds are being defaulted on left and right. But the news sounds worse than it is. Few of those defaults are by cities -- for now." Nate Berg Planet Izen August 13, 2009
"But nothing has shaken the articles of faith that underpin another massive debt market: municipal bonds. Investors in municipal bonds don’t have to worry about a thing, the thinking goes, because the states and cities that issue them will do anything to avoid reneging on their obligations—and even if they fail, surely Washington will step in and save investors from big losses. These are dangerous assumptions". City Journal By The Manhattan Institute Spring 2010 Vol 20 No. 2
"The National League of Cities says municipal governments will probably come up $56 billion to $83 billion short between now and 2012. That's the tab for decades of binge spending; municipal defaults could be our collective hangover". Fortune Magazine May 28 2010 from "Three Cities on the Brink of Broke"
"State-and-local-government finances have taken a bigger beating during this economic downturn than during any other recession since World War II. Even worse, that beating came after the easy money available during this stretch encouraged those same governments to venture well beyond any reasonable limits in terms of their borrowing. They're now stuck with a bigger-than-warranted debt load - which can't be covered by the property tax stream that's been reduced by record-level housing defaults". Money Morning " Defensive Investing: Beware Municipal Bonds" July 28, 2010
"The capital city Pennsylvania is broke and will be skipping this month's multi-million dollar bond payment. In May, Moody's knocked the rating on its general-obligation bonds three notches to B2 -- five steps below investment grade. To put that into perspective: Moody's rating on Greece's government debt sits at A3 -- still investment grade". CNN Money September 2, 2010
AND the killer...
"While portions of these bonds (Harrisburg) are insured, that shouldn’t provide much comfort because of the shaky financial position of most muni bond insurers. This includes AMBAC (ABK), the bond insurer backstopping the defaulted Harrisburg GO bonds. In AMBAC'S 2010 10Q filing they admitted we have “insufficient capital” to and “ may need to file for bankruptcy”. Most muni bond insurers except Assured Guaranteed are on thin ice too
The problem is a small flurry of municipal bond defaults that require insurance payments could cause muni bond insurers to file for bankruptcy. And then bondholders are really left holding the bag.
So how does this potentially affect investors? Well, the mainstream press has already started pointing to Harrisburg as the beginning of a widespread municipal bond collapse. If these reckless notions gain hold it could result in a selloff in state specific bond CEFs such as Eaton Vance Insured PA. Municipal Bond Fund (EIP), BlackRock MuniYield PA. Insured Fund (MPA), and Nuveen PA. Investment Quality Municipal Fund (NQP) Robert Kane in Seeking Alpha September 3, 2010 " Will Defaulted Harrisburg Bonds Cause A Domino Effect?"
HOW ABOUT STRUCTURED SETTLEMENTS?
- No structured settlement defaults during the 2008-2009 financial crisis. No defaults in 2010. As an aside there were 140 bank failures in 2009 and over 118 so far in 2010.
- Legal reserve life insurance companies must maintain statutory reserves which are certified to as many as 50 states annually.
- There is a vibrant secondary market for structured settlements backed by annuities. I received a call Thursday from a financial advisor who was seriously contemplating investing in a structured settlement transfer from an Executive Life of New York annuity.
- Structured settlements backed by United States Treasury Bonds have an even greater leevl of safety than simply buying municipals.
From 2004-2006, during which time they won back to back championships my favorite soccer team was mocked by the press for winning ugly when it mattered and grinding out 1-0 victories. On the occasions where goals flowed in a few high scoring victories (like the 8-0 premier league clincher in May 2010), a stadium full of Chelsea fans returned the "favor" by sarcastically chanting "Boring Boring Chelsea". I'd say the same thing about structured settlements. They're boring, they're not sexy, but they are safe, steady and competitive for a certain portion of your settlement.
**Structured settlement payments are income tax exempt as payment of damages, subject to the terms of IRC Sections 104(a)(1), 104(a)(2) and 130. The municipal bond tax exemption appears at IRC Section 103