How to Shop for a Muni

Marilyn Cohen, Forbes Magazine, 5.10.04

Do you really want to sacrifice yield just to get insurance on a municipal bond? You might be better off relying on diversification to get safety. Few default anyway.

Municipal bonds tend to be good investments for high-taxed investors, and these days the supply is ample. For that we can thank profligate legislatures and the cyclical downturn in tax revenues. But out of a misplaced aversion to risk, all too many investors, particularly institutions, are demanding the safety of insured munis. That's where the issuer takes out a policy that will make bondholders whole if there's a default. The insurance is not free. It cuts a slice out of your yield.

In 1991, according to Thompson Financial Securities Data, 30% of all new issues with maturities of 13 months or more were insured. By last year that figure had leapt to 54%. Memories of the Washington Public Power Supply default of the 1980s and the Orange County, Calif. default of the mid-1990s combined with recent recession malaise to propel the rush to insure.

This is an overreaction. The historic muni default rate is less than 1%. And the defaults invariably are from small, unrated issuers, like parking garage authorities and wind-power developers that you shouldn't be investing in anyway. The chances are very slim that we'll have another WPPS or Orange County debacle, especially since the economy (hence tax revenue) is on the mend.

How do you know whether a bond is insured or not? The prospectus will tell you. The information also is gettable from Bloomberg machines, if you have access to those.

Don't get me wrong. I don't think insured bonds are going to go bust. My point simply is that since you always should diversify your investments, avoiding noninsured munis is foolish. The growing investor preference for insured paper is unwarranted.

The average insured ten-year muni yields 3.95%, says Municipal Market Data. This yield is independent of the credit quality of the issuer since it's the insurance that gives the bond its credit quality. The rating agencies generally throw an AAA rating on any bond with insurance from a recognizable insurance company, although uninsured bonds (such as from Morris County, N.J.) that rate an AAA on their own are considered even safer and yield a tad less.

A single-A, ten-year noninsured bond, though, yields 4.20%. A quarter-point increment is not going to make you rich. Still, every little bit helps. And if you have your muni portfolio divided among 20 bonds from different parts of the country and with different income streams backing them (general obligation, hospital, turnpike, etc.), you have diversified away much of the default risk.

Nowadays munis, whether from insured bonds or not, have much better aftertax yields than medium-term Treasurys. For someone in the 35% federal bracket the ten-year T note, recently yielding 4.37%, delivers only 2.84% aftertax.

When might I bend my rule that municipal bond insurance is not worth the yield give-up? There are three circumstances in which you might reasonably prefer insured bonds. One is if you have too little in the market ($1 million or less) to efficiently get diversification. Another is if you prefer revenue bonds. Who's to say that the airport you are financing won't be destroyed by a terrorist or fiscal mismanagement? The third involves liquidity. If you might need to cash out before maturity, you will find that it is much easier to unload an insured bond than an uninsured one without taking a bad haircut in the price.

If you buy insured bonds, make sure that no more than 15% of them are covered by one insurer; there are other secondary sources of repayment, such as bonds that are escrowed to maturity with U.S. government bonds. The reason, again, is diversity. A big disaster could take down a single insurer. Other factors could push a municipal insurer into financial trouble. Severe price competition can erode an insurer's financial base so it can't meet claims. Management may lose its way and diversify into noninsurance businesses that are losers.

You can go to the Web sites of the four biggest insurers--Financial Security Assurance, MBIA Insurance, Ambac Assurance and Financial Guaranty Insurance Co.--to see their client lists. MBIA, Ambac and FSA for instance, are exposed to the Port Authority of New York & New Jersey. Standard & Poor's rates this quartet's claims-paying ability a pristine AAA. Much smaller XL Capital Assurance is the only other AAA in the field.

If you are looking to get in now, consider two noninsured issues whose price premiums are entirely justified. I recommend Michigan State Hospital Revenue 5s due Nov. 1, 2009, noncallable and priced at 107 to yield 3.60% to maturity. I also like the New York City General Obligation 5.25s due Aug. 1, 2014, callable 2013 for a 4.22% yield to worst call and 4.30% yield to maturity, priced at 108.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed-income money manager and author of The Bond Bible. Find past columns at www.forbes.com/cohen.

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