Advisers mull options for insured muni bonds

As the subprime crisis spreads to major municipal bond insurers, financial advisers are weighing how clients who own insured muni bonds should proceed.

Late last month, MBIA Inc., an Armonk, N.Y.-based muni bond in-surer, posted a $3.4 billion loss from marking down the value of mortgage-linked securities it had insured.

That could lead to a downgrade in the company’s AAA credit rating; the ratings of the muni bonds it insures could also be in question.

BOON OR BUST?

Depending on the underlying credit rating of the insured muni bonds, a rating cut for the insurers could either be a boon or a bust for investors, advisers and analysts said.

A muni bond insured by XL Capital Assurance Inc. of New York, whose rating was cut to an A from AAA by Fitch Ratings Inc., could see a price decline of 5% to 10% if the bond’s underlying rating is a weak single A or a BBB, according to Matt Fabian, managing director at Municipal Market Advisors of Concord, Mass.

Panicky investors who sell their bonds will miss out when the market rebounds. However, new investors can buy muni bonds on the cheap once prices fall, provided that they first inspect the credit quality of the munis, according to observers.

“You need to be cautiously opportunistic,” said Ian Weinberg, a certified financial planner and chief executive of Family Wealth and Pension Management LLC. The Woodbury, N.Y., firm manages $100 million.

“If you’re on an insured portfolio, those bonds need to be looked at carefully,” he said.

Muni bonds, which are issued by governments to fund projects, have typically been a safe haven for investors. But now clients are questioning the quality of the insured muni bonds and worrying that they may default, especially because insurance coverage can raise poorly rated bonds to AAA status.

But investors’ fears may be unfounded, according to Alexandra Lebenthal, president and chief executive of Alexandra & James Inc., a New York-based wealth management firm.

“The bonds won’t be impacted, in terms of their ability to pay interest and principal, unless they are having credit issues,” she said.

Despite the situation at MBIA, Gary Dunton, chief executive, said in a statement that he thinks that the company’s capital position will surpass AAA ratings requirements. He said that MBIA will boost its capital position by more than $2 billion.

The company raised $1.5 billion by offering surplus notes and picked up an additional $800 million through New York-based Warburg Pincus LLC’s investment in MBIA’s common stock.

Meanwhile, Ambac Assurance Corp.’s AAA rating was lowered to AA by Fitch Ratings last month.

Moody’s Investors Service Inc. and Standard & Poor’s have MBIA and Ambac, the first- and second-largest bond insurers, respectively, on a negative-ratings watch.

Ambac and the ratings agencies are all based in New York.

S&P downgraded the rating of Financial Guaranty Insurance Co. to AA, from AAA, at the end of last month.

The New York-based company is in preliminary bailout talks with banks, including Calyon, a unit of Paris-based bank Crédit Agricole SA, according to The Wall Street Journal.

FALSE SENSE OF SECURITY

The insurance gives conservative investors a false sense of security at a higher price, some advisers said.

For example, Mr. Weinberg’s clients demanded portfolios only of insured muni bonds. He eschewed these in favor of uninsured bonds with strong underlying credit, such as school district or public- transportation bonds.

“I don’t think these insurers will be out of business tomorrow, but it would be prudent not to have a whole portfolio of A-rated credits with insurance that brought them to AAA,” Mr. Weinberg said.

Given the recent reports about the tumult among the insurers, some advisers and investors are behaving defensively and selling their muni bonds.

For example, investors at Dew Wealth Management want out of munis and into corporate bonds and U.S. Treasuries, according to James P. Dew, president of the Scottsdale, Ariz.-based firm. “Every time there’s an article in a big publication, you get a few calls asking what it means,” he noted.

Dew Wealth Management manages $47 million.

Regulators also fear that mutual funds and other major bond investors that must keep AAA-rated bonds will sell off their holdings.

Eric Dinallo, superintendent of the New York State Insurance Department, has created a three-part plan to aid the insurers, including a way to raise capital for MBIA, according to the department’s spokesman, David Neustadt.

The plan aims to prevent systemic risk, he said.

Wall Street banks, which are exposed to the insurers through holdings in the companies and the guaranteed muni bonds, would need $143 billion in capital if top-rated bonds fell to A, according to Barclays Capital of London.

Mr. Dinallo reportedly has been in talks with Wall Street executives, including those at Citigroup Inc. and Merrill Lynch & Co. Inc., both of New York, about providing up to $15 billion in capital or a line of credit to the insurers to avert downgrades and a possible sell-off.

However, newcomers to the market, including those in separately managed accounts and muni bond exchange traded funds, will benefit from that value, said Thomas Doe, president of Municipal Market Advisors of Concord, Mass.

Muni bond prices will drop as investors shy away from the group or sell their holdings, he added. ETFs based on these bonds are only a few months old and don’t have any established portfolios of troubled securities, Mr. Doe said.

Investors who are already in the game should stay there, Ms. Lebenthal said. If they sell low, they will end up paying heavy commissions and missing out when the market recovers, she said.

Although unsure of what will happen to the muni bond insurance industry, observers wonder whether there will be a place for this type of coverage in the future.

WHAT IT’S WORTH

“Part of the problem is that Wall Street has been tricking investors into thinking insurance is worth something,” said Matt Fabian, managing director at Municipal Market Advisors. The coverage may not actually be necessary, because it is unlikely that a state or town will default on its bonds, he said.

Institutional investors know that the underlying rating of the bond is worth more than the insurance, added Mr. Fabian, who works in his firm’s Westport, Conn., office. “There will always be a buyer for these issues, absent something extraordinary,” he said.

Muni issuers or taxpayers also pay more than $2 billion a year for coverage, and the insurance costs sap investors’ returns, he said. There could be benefits if the insurers were out of the picture, Mr. Fabian said.

On the other hand, insurance makes small municipalities visible to investors. “There are millions of [bonds] with names no one has ever heard of in munis,” said Ronald H. Fielding, senior vice president and chief investment strategist of the muni bond group at New York-based OppenheimerFunds Inc.

“Insurance provides some liquidity, uniformity and validity,” he added. Coverage also reduces borrowing costs for issuers.

Still, nobody expects the muni bond market to go bankrupt in the event that its insurers do.

“Twenty-five years ago, there weren’t any bond insurance companies, and the market existed,” Mr. Fielding said. “People will have to start doing their homework on bond ratings, but there’s no doubt that market will exist.”

Darla Mercado can be reached at [email protected].