Insured By Whom?

Marilyn Cohen, Forbes Magazine, 05.19.08

When you shop for groceries, the checkout clerk asks, "Paper or plastic?" When your broker calls to sell you municipal bonds in the depths of the credit crisis, he should ask, "Insured or uninsured?" Your correct answer: "Uninsured, and what is the credit rating?"

The once big-three municipal bond insurers, Ambac Financial Group, MBIA and Financial Guaranty Insurance Co., desecrated their businesses by taking up a sideline that had nothing to do with municipal finance. They insured collateralized debt obligations. Those securities typically contained rotten components like subprime mortgages. Last October, as the CDO market wobbled, institutional municipal bond managers and traders came to realize that insured munis were in for a shock. Their insurers were on the hook for tens of billions in CDOs. What insurance would be left for a defaulting municipality?

The municipal market's response to this situation was swift: It became a two-tier market, with one level for insured munis with no underlying ratings and one for uninsured bonds with good credit quality. We who manage municipal portfolios care a lot about credit ratings and give credence to insurance from just three firms: Financial Security Assurance, which carefully managed its exposure to CDOs; Berkshire Hathaway, the new insurer on the block; and, to a lesser extent, Assured Guaranty, which just received an infusion of capital from W.L. Ross & Co.

Ambac, MBIA and FGIC aren't writing any new business right now, but they and other insurers are backstopping $1.2 trillion of munis issued before the CDO meltdown. At least a third of the bonds issued in the last couple of years didn't get ratings of their own; the issuers relied entirely on the insurance to make their bonds marketable. Avoid nonrated munis insured by these three companies as if they were Typhoid Mary.

Dig into your muni portfolio. Check each bond for its rating. If some bonds aren't rated and have insurance slapped on them, have your broker explain where their interest payments come from. From highway tolls? Water and sewer revenues? Courthouse or prison leases? If you're comfortable with the source and expected consistency of payments, keep the bond. If the source is questionable--say, property tax payments in an area rife with foreclosures--try to sell. However, the bid you get may be many points lower than was shown on your last brokerage statement. Or you may get no bid at all.

For months now, good-quality uninsured municipal bonds, A-rated or better, have yielded less than insured ones. The fact is, no one in the business gives any value to the insurance coverage, and you shouldn't either.

Take, for example, Palm Desert (Calif.) Tax Allocation bonds, issued for a redevelopment project, which have a 4.75% coupon and mature on Aug. 1, 2017. Because these bonds have no underlying credit rating and are MBIA-insured, they trade like an unrated security. The bonds are secured by a pledge of, and first lien on, property tax revenues. Priced at 98.15, the Palm Desert bonds yield 5% to maturity. A California resident would have to purchase an A-rated muni maturing in 30 years to earn the same 5%.

Yet that Californian would be far better off with a California General Obligation 4% due Apr. 1, 2017, rated A+ and yielding 4% to maturity. Even with an estimated $14 billion budget deficit for the fiscal year starting in July, the state, backed by an unlimited taxing power, is a sounder borrower than the Palm Desert Financing Authority.

Many New York City residents like Puerto Rico municipal bonds for their triple tax exemption. The Puerto Rico Commonwealth Public Improvement General Obligation 5.5%, due July 1, 2020, is MBIA-insured with underlying ratings of Baa3 from Moody's and BBB-- from Standard & Poor's. It yields 4.58% to maturity. I wouldn't own such a low-rated bond. New Yorkers would be better off with general obligation bonds from the state or the city; these both carry ratings of Aa3 from Moody's and AA from Standard & Poor's. For a 12-year maturity, the city's bonds yield 4.15% and the state's yield 4%.

Don't reach for yield. If you must venture beyond general obligation debt, look for reliable revenue sources such as water and sewer payments. A New York Metropolitan Transportation Authority bond rated A yields 4% to a 2012 call and 4.6% to maturity in 2020. The MTA taps transit revenues to pay the debt, so as long as New Yorkers don't start hitchhiking to work, you can rely on the coupon payments.

Marilyn Cohen is president of Envision Capital Management, Inc., a Los Angeles fixed-income money manager. Visit her home page at www.forbes.com/cohen.

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