Although municipal bond insurers have been on life support for almost two years, Ambac Financial Group’s (ABK) revelation in a Nov. 9 filing to the U.S. Securities and Exchange Commission that it might have to file for bankruptcy protection in mid 2011 should serve to remind muni investors of the need to be especially careful with what they buy.
Until early 2008, cities, towns and states across the U.S. were able to offer muni bonds at a nice premium if they were insured by Ambac, MBIA (MBI) or a handful of other companies. Now that it’s understood how insurance, once limited to munis, has been spread thinly across many riskier assets, the market has no illusions about insurers’ ability to cover losses in the event of another perfect financial storm, says Bill Larkin, a portfolio manager for fixed income at Cabot Money Management in Salem, Mass.
Despite the strong possibility that after June 2011, Ambac may not be able to fulfill its obligations, muni investors don’t have much reason for worry: bond prices have already factored in the increased risk of default, since investors no longer depend on insurance, say some bond fund managers. While it’s bound to be painful, municipal governments have no choice but to bring their spending in line with lower revenues, says Larkin. “States can raise fees, levy fees, auction off properties, lay [city workers] off. They can do some uncomfortable things, but the bond holders get paid.”
Muni prices have also been pushed down by the market’s anticipation of more supply hitting the market as cities and states feel the need to raise funds amid sharp declines in government revenue from falling property valuations, he says.
His one concern is that there could be a loss of confidence among high net worth individual investors, who dominate the muni market. Unlike institutional investors, retail investors tend to get their information from the news and could panic a little on negative headlines such as those regarding Ambac last week.
"If the market got soft because of that, I’d be in there buying [in the secondary market]. I think a lot of other people would be, too," he says.
Despite Larkin’s optimism, there are real questions about how long it will be before some of the most cash-strapped municipalities succumb to the bad economic conditions and default on their debt.
That's why Nuveen Asset Management has added research staff in order to be "even more diligent in analyzing the underlying credit on the bonds we buy," says Tom Spalding, who manages about $9.5 billion in muni assets at the Chicago-based firm.
"What we buy now that used to be insured at a triple A [credit rating] is now providing value for us, with wider spread yields," says Spalding. He estimates that bonds are 0.4% to 0.5% cheaper than they were when they carried insurance people could believe in.
Larkin at Cabot plays the muni bond market very defensively. "You want to be looking at critical services – interstate highway bonds, schools," he says. "I avoid hospitals because they have funding problems," as do some universities and airports that don’t have a monopoly on service.
Larkin scans U.S. Census Bureau data to sniff out communities with lots of children, low divorce rates and high household income. "That correlates to a high [credit] rating."
Spalding agrees that investors should stick with bonds that finance cities’ essential services, which comprise roughly 90% of what Nuveen buys.
By David Bogoslaw