Imagine insuring the success of a high-tech startup company. That's in effect what MBIA Insurance Corp. did late last year when it insured a $1.2 billion bond issue for a new Southern California toll road. In backing the bonds, MBIA lends its AAA credit rating, thus guaranteeing that the principal and interest will be paid. No matter that many toll roads never make good on all their debts. Without MBIA's stamp, the bond barely qualified as investment grade.
Fierce competition in the muni market has led bond insurers to guarantee ever-riskier issues and get paid less for it. What's more, with snail-like growth in the U.S., the major guarantors are backing foreign debt. Although overseas exposure is still small--only about 3% of a total $690 billion in insured bonds--the insurers have high hopes for foreign markets. Industry executives say they want to boost their overseas business to as much as 15% of their portfolios by 2005. That introduces a host of political, economic, and currency risks.
A CLOSER LOOK. As a result, a financial guarantor's AAA rating doesn't have the same cachet it once did. True, equity investors like the two market leaders: Shares in MBIA and Ambac Assurance Corp. are up 80% and 122%, respectively, in the past two years. But investors who buy insured bonds put less faith in the guarantee and more effort into scrutinizing the bond issuers.
"The business is largely about market share, and now virtually everything that is insurable is insured," says Clark D. Wagner, portfolio manager of Executive Investors Insured Tax-Exempt fund. The result, Wagner says, is that the insurance companies are lowering their standards. "That makes me much more cautious."
In the past, muni bond insurers earned their keep by turning high-quality A-rated bonds into AAAs. But today, they also are backing more bonds that would otherwise earn only BBB ratings--the lowest investment grade.
In some cases, the insurance companies have dipped even lower and turned junk muni bonds into AAAs. Last year, MBIA insured post-bankruptcy Orange County bonds that were below investment grade. They also put their stamp on a startup toll road in the Denver airport area. "We are very positive on the L.A. and Denver areas so we felt these issues were good credit risks," says Neil Budnick, president for public and corporate finance at MBIA.
Of course, there's a good case to be made for the insurers casting a wider net. They're financially sound, and most haven't had to pay big claims. "There's now a broader definition of what's insurable, but I don't see any increased risk," says Roger K. Taylor, president of Financial Security Assurance Inc. Ambac Assurance Chairman and Chief Executive Phillip Lassiter admits that some of the bonds he insures today would not have been backed five years ago. But he says the company works with the issuers to restructure deals in ways that enhance the credit quality. MBIA does the same.
In the heat of battle, insurers are undercutting each other. For instance, the premium for a BBB-rated airport bond is now the same as the insurance companies charged for an A-rated airport bond four years ago. That means the companies are taking on more credit risk for less money. "Premium rates have dropped over 25% in the last six years," says David Litvack, senior director of municipal structured finance at Fitch IBCA. Of course, the economy and the finances of most issuers have strengthened during that period, making the insurers even less likely to face a claim.
WHAT IF? But the financial guarantors back long-term bonds, and the domestic economic environment may not always be so robust. No doubt the overseas markets are now very different than when the insurers first took on the business. Consider the recent turmoil in the Asian markets. "The bond insurers had manageable risk this time because they had little exposure," says Dick P. Smith, managing director for bond insurance ratings at Standard & Poor's Corp. Before the crisis hit, MBIA backed a $200 million issue for the Kingdom of Thailand while Ambac insured a $100 million bond for the Korean Development Bank. Both issuers are current in their payments. "What would have happened if they had 15% of their portfolio abroad, and we were hit with the turmoil in Asia?" asks Smith.
Certainly, financial guarantors will do whatever is necessary to maintain their AAA ratings. But will investors take as much comfort in them as they once did? Now, rather than just monitoring the issuers, muni bond investors must monitor the insurers as well.