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Funds Caught in the Bond-Insurer Storm

Some smart investors don't see doomsday for these firms.

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Bond insurers have been in the news lately, and not in a good way. Until a few months ago, most people probably hadn't even heard of these companies, but they're now at the center of a storm that has put enormous pressure on the U.S. stock and bond markets. Possible changes to the credit ratings of big bond insurers such as  MBIA (MBI) and  Ambac (ABK) have made headlines, and all of the bond insurers are fighting for their lives as they try to raise capital.

The whole mess is an indirect result of the ever-expanding subprime-mortgage crisis. Bond insurers guarantee payments on some $2 trillion worth of municipal bonds, a boring but profitable business that lubricates the world economy by allowing cities and states to borrow money more cheaply. A few years ago, some of them expanded into the hotter, more lucrative business of insuring collateralized debt obligations, including many backed by subprime mortgages. Now the anticipated losses from those CDOs are weighing on the bond insurers' capital requirements and threatening their crucial AAA credit ratings. If those credit ratings are downgraded, many insured bonds would also be downgraded, forcing the many banks and other institutions that own the bonds to write down their value. That would cause major headaches throughout the financial system.

This crisis has had an especially significant effect on certain corners of the market, including some mutual funds. For example, funds that specialize in insured muni bonds, such as  BlackRock Municipal Insured (MAMIX), have underperformed their peers over the past few months, though they're mostly still in positive territory. More seriously affected have been funds holding the stocks of the major bond insurers, several of which have been hit very hard. MBIA is down 79% over the past 12 months through Feb. 5, Ambac is down 87%, and  Security Capital Assurance (SCA) is down 90%.

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David Kathman does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.