"Who Needs It?"

• Municipal Bonds: Still the Second Safest Investment Against Default
• A Case Can Be Made For A “Aa/AA” Rated Bond Insurance Industry – It’s Been a Long Time Coming
• Current Developments And Increased Concern Over Subprime Mortgage Defaults
• If “Aaa/AAA” Ratings Are Downgraded, How Will That Affect Outstanding Debt?

It’s ironic that municipal bond insurance, which was first marketed as the safety net that allows investors to “sleep at night”, is now causing sleepless nights all across the $2.5 trillion dollar tax-exempt bond market. The bond insurers are decades away from their original claim to be able to fully withstand a “Great Depression” scenario of bond defaults, and still be able to guarantee full and timely payment of principal and interest on the municipal bonds that they insured. Indeed, the bond insurers no longer even refer to themselves as municipal bond insurers – they call themselves financial guarantors, and back the debt of such widely diverse and riskier credits such as investor-owned airlines, football teams, chains of pubs and exotic structured securities. But that doesn’t mean that insured municipal bonds are not a good buy for investors.

Insured bonds have a foundation of underlying safety that is not captured in the ratings that were assigned based on bond insurance. Insurance payments only kick in after an issuer cannot pay its debt on its own, but defaults by these issuers are rare. Several studies have been done that document the low rates of default on municipal bonds, and corroborate the old axiom that municipal bonds still have the second-lowest risk of default (non-payment) after United States Treasury debt. In fact, the frequency of non-payment on munis is comparable to the rate of default on “Aaa/AAA” rated corporate debt.

In 2007, Moody’s published a report that said its municipal ratings are much lower than what they would be if they were assigned on a comparable basis with all of their other debt ratings. A “map” that was released at the time of the report showed that all of their state and local general obligation bonds which they rate as low as marginal investment grade “Baa3” would be rated no lower than “Aa3”, if they were to be rated on the same scale for default risk as all of their other debt ratings.

That doesn’t mean that your insured bonds won’t be downgraded. Increasingly, it appears that the rating agencies will bite the bullet and downgrade insured bond ratings, perhaps below the “Aa/AA” range, as was the case when Moody’s downgraded FGIC to A3 on February 14. These downgrades do not mean that your bond is likely to default. It just means that the back-up protection of bond insurance is not as strong as it once was. Other than the impending negative effect of recession, there is no more risk of default by the issuers themselves than there has been in past decades. So, even if the bond raters downgrade the bond insurers below “Aaa/AAA”, the issuers that ultimately pay the debt service on your municipal bonds are still expected to remain strong and pay debt service on time with little risk of default.

The simple truth of the matter is that the bond insurers probably deserve to have their guaranty ratings lowered from the once-considered invincible status of a “Aaa/AAA” credit rating. In the last decade, more than half of their new insurance exposure has been in the higher-risk corporate and structured debt sectors, much of it in the now infamous sub-prime mortgage sector. The rating agencies have downgraded a great deal of this debt, once believed to be protected at “Aaa/AAA” rating levels. Those downgrades continue, and no one really knows when the full extent of default risk in this sector will be measured with any certainty.

So, what should a retail muni investor do in these conditions?

If you do not need to liquidate your investments for cash, the best strategy is to hold onto your insured bond holdings until markets stabilize. State and federal regulators are working on solutions that will hopefully stabilize the backing of bond insurance and maintain or restore insurers’ “Aaa/AAA” ratings.. There will also be pressure on bond rating agencies to increase the publication of corporate-equivalent municipal bond ratings that truly reflect the safety and low risk of default of munis. And if both of these initiatives fail, the market will still try to adjust as more information becomes available on the underlying ratings and safety of munis. Selling your insured munis in today’s market is bound to yield poor pricing, as many large institutional investors and funds are liquidating their insured holdings to comply with money market regulations and internal investment guidelines.

If you can afford to be a long-term investor that does not need cash in the next year or two, there may be no better time to accumulate larger amounts of tax-exempt debt than now. Forced sell-offs of munis by large institutions are creating low prices and buying opportunities in insured munis, especially if you know the strength of the underlying issuer for your insured bonds.

The material presented here is for information purposes only and is not to be considered an offer to buy or sell any security. This report was prepared from sources believed to be reliable but it is not guaranteed as to accuracy and it is not a complete summary of statement of all available data. The purchase and sale of securities should be conducted on an individual basis considering the risk tolerance and investment objective of each investor and with the advice and counsel of a professional advisor.