Beware of bad municipal bond insurance

Oct 16, 2012

Municipal bonds are relatively safe investments. So insured municipal bonds should be a sure thing, right?

That's not a safe assumption.

Thanks to the financial meltdown, that insurance may not offer any protection. Financial commentator Greg Heberlein explains why on this week's Money Matters with KPLU's Dave Meyer.

For the past half century, the rage in municipal-bond investing has been insurance. Beginning in the early 1970s, sewer districts, cities and states could sell bonds to the public and buy insurance to make sure the interest is paid and you get your money back.

Less than 10 years ago, 60 percent of all new municipal bonds were purchased with the insurance feature. But something went wrong, and now only 5 percent of new bonds are insured.

What went wrong was the subprime-mortgage catastrophe.

The bond insurers got greedy and began insuring the mortgage market. When the 2007 crash struck, the insurers were forced to pay off. Since they insured nearly $3 trillion worth of bonds overall, even a relatively small number of state and local bodies refusing to pay up threatened their survival.

Outside agencies immediately began to hack into the insurer’s gold-plated triple-A ratings. Most dropped quickly into junk-bond status. 

When a municipality buys insurance, in effect it takes on the insurer’s rating. Triple-A was the standard for 40 years. Now it is far less; some insurers have gone bankrupt, and municipalities are avoiding buying the insurance in droves.

As governments scramble for revenue in our weak economy, more of them are deciding to pay their police instead of their bondholders.

If the issuer of a bond declines to pay, and the insurer is no longer around to make good on the deal, what happens? The same thing as if no insurer ever existed. The government that borrowed the money must pay it back. But like any bankruptcy, you as the municipal-bond holder could see no interest or principle payments for years.

How can you protect yourself? 

Bond funds help. They are big and can absorb most defaults. Because they trade frequently, they already may have dumped their less-than-secure insured bonds. Bond funds have potential problems, but faulty insurance would be minor.

All investors should pay attention to bond ratings. If a bond is rated high-grade, for example single-A, double-A or triple-A, make sure it’s not because of the insurance feature. When you buy a bond, make sure the full faith and credit of the government entity is behind it. Revenue bonds, such as a new bridge backed only by its tolls, should be avoided at all costs.

The issue boils down to individual responsibility. If you cannot understand the primary details of the sales brochure (called a prospectus), remember the phrase “buyer beware.”