Why Municipal Bonds Are Stumbling

Municipal bonds generally keep a safe distance when financial firestorms threaten to wreak havoc in other areas of the bond marketplace. But now some triple-A rated tax-exempts are getting thrown into the dreaded subprime mortgage inferno.

The problem isn't that falling real estate values or growing default rates among mortgage holders are causing fiscal problems for state and local governments or school or public utility districts. Municipalities have plenty of ways to cope with budget shortfalls before they get remotely close to defaulting on their debt.

If you're a buy-and-hold, income-oriented investor who owns individual tax-exempts rated single A or better, there's no reason to sell. And there's no reason to avoid new issues.

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But total-return investors and holders of bond funds, especially the leveraged kind, do have something to worry about. Municipals are the second-worst-performing class of bond in 2007, barely ahead of corporate junk bonds, and things could get worse.

The problem. The weak performance is tied to concerns about the health of bond insurance companies, relatively obscure entities that go by such acronyms as Ambac, FGIC and MBIA. These companies insure roughly half of all the tax-exempt bonds outstanding for the eventual repayment of principal and any missed interest payments.

On their own, these bonds would typically merit a triple-B or single-A rating, perhaps occasionally, a double-A rating. The insurance upgrades them to triple-A status in the eyes of the market. This allows state and local issuers to pay less interest on their bonds.

Saving money on interest, not compensation for potential defaults, is the real purpose of muni-bond insurance. Claims are rare, and what few there are usually stem from embezzlement and other forms of fiscal chicanery, not general financial market risks.

Because defaults are rare, the "financial guaranty" industry is enormously profitable -- or at least the bond part of it. But bond raters Moody's, Standard & Poor's, Fitch Ratings and A.M. Best, as well as some bond analysts, are now examining the bond insurers closely.

They want to know to what degree the insurers could be exposed to losses from their secondary business of guaranteeing collateralized debt obligations and other pools of asset or mortgage-backed securities.

If the insurers lose their triple-A status because of losses in these assets, the municipal bonds they guarantee will also lose their top rating. Prices of those bonds would drop because their yields would reset to the higher level of a lower-rated bond.

It is this prospect that explains why many insured munis have been losing value even as prices of Treasury bonds seem to rise almost every day.

The situation still may not deteriorate enough to force the ratings agencies to cut anyone's triple-A status. But "this has become a credit story and there's significant fear in the markets whenever there's a credit story. That's a fact," says John Miller, a municipal bond manager for Nuveen Investments.

Another bond trader, who asks to remain anonymous, says insured municipal bonds are trading for 5% less than they should be worth because of a belief, which he shares, that Ambac and MBIA will need to raise new capital or suffer a notch or two cut in their ratings.

The stocks of both Ambac and MBIA, which issue the bulk of the municipal bond insurance, have plunged. That means they can't easily raise money by selling new shares or convertible bonds. In a pinch, they might be pressed to copy Citibank and find a rich partner.

The ratings agencies are caught in the middle. S&P and Moody's took all sorts of grief for being too slow to downgrade subprime mortgage securities. They're in no mood to wink at another fiasco, but they also don't want to send the municipal bond market into a needless downward spiral.

Both S&P and Moody's offer their analyses of the bond insurance situation on their public Web sites. That tells you this is serious because such reports are usually only available to paying subscribers and the press.

The market speaks. Bond investors are weighing in. Their conclusion appears to be that the insurers' problems are serious. As a result, the cost to bond holders is mounting.

Normally, Miller says, the difference in yield between a bond that's rated AAA (S&P) or Aaa (Moody's) on its own merits and an insured bond is 0.08 to 0.12 percentage point. Over the past couple of months, as the insurers' condition has become an issue, this spread has widened to as much as 0.45 percentage point.

To put it another way, that means that an insured, triple-A highway or sewer bond is being priced as if it were an uninsured muni rated between single-A and double-A.

This stealth downgrade doesn't affect the security of the principal or interest payments. But it's a significant loss of value for bondholders.

Currently, there are about $2.5 trillion to $3 trillion in municipal bonds, half of which are insured. The average yield now for a 20-year insured bond is 4.3%. Assume that those bonds would yield 4% if there were no questions about the health of the insurers. The difference in price works to about 4 cents per dollar on a bond due in 2027.

That may not seem like a lot, but it's a big loss in such a stable category, and the losses could get bigger if the ratings agencies turn up their rhetoric or actually downgrade the insurers.

Another sign of pressure is the action in leveraged closed-end municipal bond funds. Although these funds don't invest exclusively in insured bonds, the discounts between the funds' share prices and their net asset values are widening -- a sign that investors see extra risk.

Discounts for four leveraged and insured funds--- Insured Muni Income Fund (PIF), Nuveen Premier Insured Muni (NIF), Morgan Stanley Insured Muni (IIM) and BlackRock Insured Muni Income Trust (BYM) -- have widened considerably since last summer. Their share prices are down by 7% to 12% in six months.

By the standards of a bear market in stocks, these losses aren't horrific. There may even be a bright side to the insurers' travails: More munis may come to market without insurance, meaning higher costs for taxpayers but better yields for bond buyers.

Still, this is about the worst performance spell for muni bonds since 1999. That it came out of left field and at a time when so many investors covet safety and stability is dismaying.