Munis: How Safe?

Bond insurers who back municipal bonds are on shakier ground. Here's what that might mean for your portfolio

Municipal bonds are supposed to be a safe, boring investment for the risk-averse, but the credit crisis has shaken up even this quiet corner of the fixed-income market.

Rising concerns about bond insurers—also known as financial guaranty firms—have called into question a key layer of protection for many municipal bonds. That has spooked investors, who wonder if the munis they assumed were ultra-low-risk are still safe.

Bond experts say the vast majority of muni investments are still secure. However, individual investors should scrutinize their holdings carefully. Also, worries about bond insurance may complicate life for institutional investors and for government bodies that issue the bonds.

Insurers Undermined by Subprime Debt

On Dec. 19 ratings agency Standard & Poor's raised questions about the creditworthiness of six firms that insure bonds and other financial instruments. The credit rating of ACA Financial Group (ACAH) was downgraded to junk status, while S&P raised red flags about credit problems at other firms such as large insurers Ambac (ABK) and MBIA (MBI). (S&P, like BusinessWeek, is a unit of the The McGraw-Hill Companies (MHP).) On Dec. 14 another ratings agency, Moody's (MCO), had issued similar warnings.

It was insurance on risky debt that got these financial guaranty firms into trouble. A particular problem spot: securities backed by subprime mortgages.

Despite their ventures into this riskier arena, the companies still play an important role in the quieter municipal bond market: About half of muni bonds carry guaranty insurance, with the firms promising to back up the bonds if they default. While that protection remains in place, at least on paper, most muni investors no longer trust it. Even before the most recent news, many bonds were being traded as if they didn't have insurance at all.

Experts say that questions about insurance make it far more important for investors to assess the underlying creditworthiness of the issuer, whether that is a state, a city, or another body.

Default Risk Is Still Slim

The good news? For the vast majority of these bonds, the chance of default is still "minuscule," says municipal fund manager Charlie Hill of T. Rowe Price (TROW). In fact, the record of muni bonds is so good that many have questioned whether insurance is necessary in the first place. The credit quality of bond issuers is much higher than that of the bond insurers.

For most investors, says Matt Fabian of Municipal Market Advisors, the lack of insurance "doesn't affect your ability to get repaid." This should be reassuring to most individual investors, who are mainly interested in the income muni bonds provide, not in trading them.

There is a reason to worry, however, if you invested in the rare, riskier parts of the muni bond market, like hospitals. Insurance did make bonds from those issuers more attractive. Thus, experts say, investors should closely scrutinize their holdings and make sure the underlying bonds are secure.

Much of the worry about bond insurers isn't new. The market had been expecting ratings agencies to act for months, so the impact of the moves had already affected the prices of many riskier bonds, Hill says.

Opportunities in Volatility

For those looking to load up on more muni bonds, the turmoil might present buying opportunities. Some high-quality bonds are available at lower-than-normal prices and higher-than-normal yields. "If you are a municipal investor, now might not be a terrible time to step up your investments," says Lawrence Jones, a fixed-income mutual fund analyst at Morningstar (MORN). Muni bonds are increasingly competitive with ultrasafe Treasury bonds, with the added benefit that muni bonds often offer tax advantages, Jones says.

"Volatility [in the muni market] creates an opportunity for individuals," Fabian says. However, "it makes it harder for institutions to invest."

Insurance simplified the muni market for hedge funds and other institutions, giving investors a quick way to categorize the risk from the thousands of cities, states, and other bodies that issue the bonds. With that no longer a sure thing, they may retreat from the space. It's not clear yet whether the bond insurance will ever play a key role in the market again. If the market loses confidence in insurance, the extra cost of its protection may seem increasingly unnecessary. If that's so, governments with riskier credit may see their borrowing costs increase somewhat.

Despite the trouble in the usually serene muni market, it's clear that muni bond investors will feel only a small amount of pain. That's the advantage of investing in a relatively risk-free investment, though these days, even the safest holdings are feeling the effects of the credit market's malaise.

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