Funds Caught in the Bond-Insurer Storm

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  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 , 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  is down 90%.

We decided to see which funds have the greatest combined percentage of their portfolios in MBIA, Ambac, and SCA. We didn't include the other publicly traded bond insurer,  Assurance Guaranty (AGO), because it mostly avoided insuring the riskiest CDOs and has actually gained 46% in the past three months. We also didn't include  PMI Group  or  Radian Group (RDN), which have stakes in bond insurers but are primarily in other businesses. (PMI Group owns 42% of FGIC, and Radian Group owns Radian Asset Assurance).

The following table lists each fund's category, assets under management, the percentage of its portfolio in the three stocks noted above, and percentile ranking within its category for the six months through Feb. 5, when the bond-insurance crisis has unfolded.

Biggest Bond-Insurer Bets
	Category	Size ($Mil)	% in 3 Stocks	% Rank Cat 6 Mo.
Matthew 25 (MXXVX)	Mid-Blend	66.1	10.51	93
Harbor SMID Value	Mid-Value	2.8	9.61	98
Legg Mason Spec Investment (LMASX)	Mid-Blend	2,525.1	5.34	99
Blue Chip Investor (BCIFX)	Lg Growth	23.6	4.25	31
Fidelity Select Insurance (FSPCX)	Financial	169.4	3.93	23
Allianz OCC Value	Lg Value	1,269.4	3.90	92
Cambiar Opportunity (CAMOX)	Lg Blend	1,894.7	3.61	76
Legg Mason Partners All Cap	Lg Growth	893.5	3.50	99
American Century Value (TWVLX)	Lg Value	2,360.8	3.49	80
Crawford Dividend Growth (CDGIX)	Lg Blend	36.9	3.09	79

The top three funds on the list have all been hurt badly in recent months by their positions in the three beleaguered bond insurers, as their rankings show.  Matthew 25's (MXXVX) entire 10.51% stake comes from MBIA, which was its second-largest position as of Sept. 30; Harbor SMID Value  has big positions in both Ambac and MBIA, which were its second- and third-largest positions as of Dec. 31; and  Legg Mason Special Investment (LMASX) has smaller positions in all three insurers, with Security Capital Assurance breaking into its top 10. Harbor SMID Value just launched last year, but the other two funds tend to be contrarian offerings with long time horizons, so it's not too surprising to see them holding such out-of-favor stocks. The Legg Mason fund used to be run by legendary contrarian Bill Miller, and current manager Sam Peters used to run a financials-sector fund for Fidelity.

Of the other seven funds in the list, only two have beaten their categories over the past six months. One of these,  Fidelity Select Insurance (FSPCX), is a special case because it only holds insurance stocks, most of which (other than the bond insurers) have done quite well relative to other financials. The other five funds are all in their respective categories' bottom quartiles over the past six months, but several have better prospects over the long term. Colin Glinsman of  Allianz OCC Value  actually has an excellent long-term record with  Oppenheimer Quest Balanced (QVGIX), but in 2007 he got burned badly by housing- and subprime-related bets--not just the bond insurers, but also such stocks as  Centex  and  Countrywide . Similarly,  Cambiar Opportunity (CAMOX) has put up stellar long-term returns under lead manager Brian Barish but got hit hard in 2007 by subprime woes in its financial holdings.

There's still plenty of uncertainty surrounding the major bond insurers, and it's too early to say for sure how likely they are to recover fully. However, there are some smart investors who think that they'll make it through this crisis just fine. In addition to the managers noted above, legendary value manager Marty Whitman holds MBIA and Radian Group in his  Third Avenue Value Fund (TAVFX). In his fourth-quarter shareholder letter (which you can read in PDF-form here, he explains why he still likes these stocks--they're cheap, financially strong, well-managed, and unlikely to be liquidated despite the doomsday scenarios. Investors like Whitman are betting that the market's reaction has been overblown, and the next few months should tell us whether that's the case. (To learn more about Third Avenue's investment in bond insurers, click here to watch Justin Fuller, the manager of Morningstar's Ultimate Stock-Picker's Portfolio, interview Third Avenue Management's Curtis Jensen.)