From the May 2008 issue of Boomer Market Advisor • Subscribe!

Don't lose sleep over bond insurer stress

Media coverage of bond insurer problems are shaking up the municipal bond market. Investors who own municipal bonds are worried about insurers' portfolio losses and possible changes in credit ratings. But advisors who reveal the underlying causes of insurers' woes can suppress their clients' fears and open the dialogue for unique investing opportunities.

Historically, a monoline insurer's role was to enhance the credit quality of investment products by attaching an insurance policy to the credit. Issuers paid the insurance premium in order to lower the interest rate attached to the security and get a higher rating for their bond offerings. If a borrower defaulted, the insurer would guarantee the timely payment of interest and principal. Insurance increased a municipal bond's creditworthiness and liquidity.

But over the past 10 years, the monoline firms began insuring structured finance products, such as collateralized debt obligations. The insurers' problems arose when, in the wake of the credit crunch, CDOs and similar products significantly dropped in value and insurers had to raise their cash reserves if thay wanted to maintain their credit ratings. As a result, rating agencies began analyzing whether the insurers held enough capital to justify their AAA ratings. So far this year, each bond insurer has been reviewed several times. Some firms were downgraded from
AAA, but the majority of AAA insurers maintained their rating.

Insurer woes created unusual valuations in the municipal market. For instance, bonds supported by the weaker insurers were valued as if the insurance did not exist at all, meaning that a buyer of these bonds could get the insurance for free. In some cases, bonds with insurance traded at higher yields than the same credit without the insurance.

Moreover, throughout the first quarter, high-quality municipals offered yields greater than Treasury bond yields. That difference existed even before taking into account the tax advantage or tax equivalent yield of municipals over Treasuries. And with the presidential election around the corner, the potential for higher tax brackets may make municipals look even more attractive as investors try to minimize their tax bills.

Investors should be aware that there has been no fundamental change in the credit quality of the underlying municipalities. The economy is slowing but they are still highly rated credits on their own - even without the insurance. You can remind your clients that, historically, municipals have had an extremely low default rate.
Insurance is used mostly for improving the marketability of bonds and is rarely called on to cover a default.

But the current uncertainty surrounding insurers creates opportunities for investors. While it is true that individuals can buy specific issues, the challenging market environment suggests that the best approach to investing in municipals is to diversify both in sectors, duration and geography. To that end, investors are well served by choosing a municipal bond fund that is actively managed. Experienced research teams have the time and capability to analyze the full spectrum of municipal credits to find attractive values. Even before the bond insurers faced problems, our investment research group closely examined the underlying credits for insured bonds. We still see strong credit quality for municipals, but as the economy slows in 2008, research will be key in determining the strongest issues.

Talk with your clients about whether municipal bond advantages -- tax relief, low default rate and potentially better returns when compared with Treasuries -- will enhance their portfolio. Investors should look for municipal bond funds that are supported by a strong investment group that has extensive experience analyzing the value of
each issue.

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