Muni Bond Holders: Don't Lose Sleep Over Insurance Guarantee Failure

by: David Merkel January 20, 2008 | about stocks: ABK    
David Merkel

David Merkel

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Here's a Reader's Question:

Hi David, I really enjoy your blog very much. Your recent post regarding AAA bonds brings up a question for me and I’ve seen several different answers in the press and on TV.

I have about 35% of my portfolio in triple AAA muni bonds–most insured, but not all. My intention with insured AAA bonds was to not have to worry about them.

I’m now reading about the potential bankruptcies of the muni insurers–AMBAC, etc. I heard on the tube today that “we will see a muni bond crash” if the ratings on these insurers are lowered. After the close I saw where one was lowered to a AA rating. This is not what I like to hear and I suspect with further reading that the comment was overblown, possibly irresponsible.

I hold my bonds to maturity with my principle concern of income generation. Is this something one should be worried about? Anything specifically about the individual bonds that should raise read flags? As I live in Arkansas, most are Ark. munis although I’ve got some from Puerto Rico. Thanks for any insight on this. And keep your great posts coming.

I don’t think you should be very worried. Municipalities rarely default. When they do default, it is typically for a little while, and then payment resumes. So long as a municipal bond has an economic purpose behind it — a necessary city, county, state, or project, defaults are rare.

The financial guarantee is a way of making the bonds thought-proof. Bond mangers don’t have to do credit analysis; the guarantee is enough. The guarantors aren’t dumb (at least with respect to municipals), they know what doesn’t deserve a guarantee.

Without knowing exactly what you own, I can’t say it with certainty, but I can say it is likely that you will come out okay if all you hold are munis that have an economic purpose. (Be careful on the Puerto Rican issuers, I know little there.) That said, the market value of your bonds have likely declined a little due to the possible loss of insurance protection. If you are, truly, buying and holding economically necessary issuers, you should end up fine.

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This article has 4 comments:

  •  
    Jan 20 07:13 AM
    your logic may be flawed - if the stand alone bond was credit robust, insurance would not have been required -
    Reply | Link to Comment
  •  
    Jan 20 10:59 PM
    If your bonds are backed by property taxes or an essential revenue stream such as water charges, I wouldn't worry about the bonds. They probably didn't need the insurance to begin with, but a lot of buyers were willing to pay higher prices (accept lower interest rates) for insured bonds so the bonds were insured. On the other hand, if your bonds are backed only by lease payments to be made by a financially weak city that you would not want to live in, you have more to worry about. If the retirement system for public employees is not fixed in California in a few years, I could easily see some California issuers defaulting on their lease bonds (certificates of participation) down the road.
    Reply | Link to Comment
  •  
    Feb 13 01:57 PM
    your assumptions are faulty - granny's nursing home, and other cats and dogs, are in the mix - wait til the institutions have to dump post downgrade - you may see a significant loss in value - all in all, a potential cesspool
    Reply | Link to Comment
  •  
    Feb 15 09:12 AM
    While I certainly hope your bonds are safe, I have to say things have a way of coming around the backend lately with risk you never counted on. Please review articles in the WSJ and other places by doing a google search for auction rate municipal bond failures. Right now over 1000 failures of these short term muni bond papers many AA paper have failed. While the underlying securities have not defaulted there is no liquidity. Here is the problem, some of these municipalities which included places like the Port Authority of NY etc have been forced to pay crazy rates of interest (up to 20%!!!). This is not possible over the long term and with the middle class up their ears in "unnannounced inflation" as I call it, property taxes, tolls and other fees might be in jeapordy that noone ever thought would be.

    People affected by these short term money market like instruments being frozen are everywhere and there money is locked up.

    This cannot be good for the market. While the insurance might not be important, illiquidity can cause problems for anyone and lead to other problems.

    I wish I could talk to those in the know about this issue because if you peak behind the news everyone I talk to sees this as a potential systemic problem that is just getting noticed now. It is very serious and is unprecedented.

    Marty
    Reply | Link to Comment
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