Sunday, November 16, 2008

The Warren Buffett Way: Chp 6 Part 3: Fixed-Income Marketable Securities

Washington Public Power Supply System (WPPSS):

In 1983, WPPSS was in default of $2.25 billion of municipal bonds. The state had made a ruling that the local power authorities did not have to pay WPPSS for power they had previously committed to purchase. The money raised from these in-default bonds was supposed to be used to complete the construction of two nuclear power plants. The construction of the power plants was in jeopardy due to the state ruling. At the time, this was the largest municipal bond default in US history.

WPPSS had other issued other municipal bonds which were used to fund entirely different projects. However, the value of all WPPSS bonds were marked down pessimistically in the marketpalce, even those bonds that were not directly tied to the financing of the construction of the nuclear power stations. Buffett evaluated the risks of other WPPSS municipal bonds, specifically those for projects 1, 2 and 3, which were tied to existing operational projects and were direct obligations of the government agency, Bonneville Power Administration. When the WPPSS bonds for the nuclear project defaulted, WPPSS project 1,2 and 3 bonds declined significantly and were yielding a tax-free return of 15-17 percent.

Through Berkshire Hathaway, Buffett purchased $139 million of WPPSS projects 1, 2 and 3 bonds, when their face value was $205 million. From a business point of view, the $139 investment would produce an after tax cash payment of $22.7 million. Buffett explained, that there were very few investments available at that time that were selling at a discount to book value and able to produce such a high, unleveraged, after-tax rate of earnings. These bonds ended up doubling in value while paying Berkshire a tax-free high rate of return on capital.

This is an example of a "fallen angel" Buffett bond purchase.

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