Bond Insurance: Friend or Foe?

The bond insurance industry has become a genuine spotlight hog in muni-land. It's no wonder: Several of the monoline insurance companies, which guarantee roughly half of the $2.5 trillion of municipal debt outstanding, have taken it on the chin lately. Like most everything else that's gone wrong in the bond market over the past year, trouble for the insurers started with escalating subprime-mortgage defaults in 2007. As several insurers had expanded into the business of backing mortgage-related securities, investors and credit rating agencies have been scrambling to get a handle on the insurers' exposure to the mortgage mess. Given the many unknowns in the housing arena, that's no easy task.

And municipal-bond funds haven't escaped the impact of the insurers' woes. In an already risk-averse climate, downgrades--and the threat of downgrades--have put additional pressure on bond prices as investors demand higher yields to compensate for added uncertainty. In the not-so-distant past, the market treated bonds backed by the seven AAA rated bond insurers almost interchangeably, but the situation looks much different today. Now, only two of those companies--Assured Guaranty and FSA--have retained solid AAA ratings (the new Berkshire Hathaway entrant also lands in this camp). The two largest, most established insurers--Ambac and MBIA--have struggled to keep their AAA ratings from Moody's and Standard & Poor's. S&P downgraded both to AA on June 5, one day after Moody's put them on review for a possible downgrade. Finally, ratings on the weakest of the pack--CIFG, FGIC, and XLCA--have slipped to junk status, according to one or more of the three major rating agencies.

These downgrades partly explain why munis have continued to deliver anemic returns so far in 2008. The market has directly punished bonds backed by downgraded insurers, in some cases assigning zero to negative value to the insurance. Also, uncertainty surrounding the insurers' ability to make good on their obligations exacerbated the lack of liquidity already present in the market, as leveraged muni buyers faced margin calls and the auction rate securities market suffered disruptions.

Not Disastrous, But Not Defensive
In reality, the insurance-related turmoil, while contributing to a slump for muni funds in general, hasn't automatically spelled catastrophe for the handful of insured muni funds out there. In Morningstar's long-term national muni category, where insured funds have the biggest representation, results were mixed.  Franklin Insured Tax-Free Income  has shown off its defensive prowess, ranking in the broader category's top quartile for the year through June 4, while  Vanguard Insured Long-Term Tax-Exempt  has landed near the middle of the pack. By contrast, insured offerings from Nuveen and BlackRock have struggled this year, while  Van Kampen Insured Tax-Free Income  has earned the dubious distinction of the worst-performing fund in the long-term muni field so far in 2008. It shed a total of 5% over the previous 12 months, ranking second to last in its peer group.

Of course, insured funds weren't the only ones to experience downgrades in their portfolios, and a number of other factors have contributed to these funds' disparate results over the past year. In the case of the Van Kampen offering, for instance, downgrades were the least of its concerns. Instead, a poorly timed bet on highly volatile (and uninsured) tobacco-settlement issues, a hefty dose of struggling long-term bonds, costly use of derivatives, and a cumbersome fee hurdle have all taken a heavy toll. The Franklin fund, on the other hand, has benefited from the team's practice of holding on to issues that have been prerefunded (26% of the portfolio). Because prerefunded bonds are backed by Treasuries, investors' strong aversion to all types of risk has made them that much more desirable, giving this fund a boost.

Roll Up Your Sleeves
All the bond-insurance commotion serves as a useful reminder that an insured mandate alone won't make a fund defensive. In addition to the struggles of some insured funds, recent performance of two Lehman indexes bears that out: The Lehman Brothers Municipal Bond Index gained half a percentage point more than its insured counterpart for both the 12 months and for the year to date through April 30. Relying on external credit ratings won't cut it either. On the contrary, some of the most successful fund managers of late (and over the long haul) never lose sight of the fact that beneath every insurance wrapper, there's a bond with a specific structure, covenants, collateral, and other security provisions, as well as an issuer with assets, liabilities, cash flows, managers, and competitors--all of which should be carefully considered before a bond is purchased and continuously monitored once it's in the portfolio. Ultimately, a management team's ability to sort through these fundamentals will help determine just how much protection the fund can offer in turbulent times. Documents must be parsed and tires kicked-- there's just no way around it.

Many of the muni shops we'd invest with, particularly those at Fidelity and Franklin, have weathered a difficult period admirably by not taking any shortcuts when it comes to doing the necessary work. Mary Miller and crew behind  T. Rowe Price Tax-Free Income (PRTAX) (and the rest of the T. Rowe muni lineup) have also shown off their knack for playing solid defense without the help of crutches. They've always evaluated a bond on its own fundamental merits, typically sidestepping yield-poor insured bonds in favor of using their own credit research to pick through more attractively priced uninsured alternatives. When buying insured bonds, they've been careful to review the credit risk of the underlying bond, which protected the fund from the price swoons of dramatic downgrades. And like peers at Fidelity and Franklin, a hefty slug of prerefunded issues has helped buoy T. Rowe's muni funds through turbulent waters.

Eyes on the Fundamentals
Even before the latest crisis, we weren't diehard fans of funds that invest primarily in insured munis. Because insured bonds come with an extra layer of support, they don't typically offer the most appealing yields in the market. And given the historically miniscule rate of defaults for investment-grade munis, insured funds don't provide much added protection. Now that a chink in the armor of bond insurance has been exposed and the future of the industry is being hotly debated, the answer to the question of whether or not to invest in an insured muni fund over a more flexible offering seems fairly clear. On top of that, the amount of newly issued insured bonds has dwindled in 2008, and insured funds, at least for now, have fewer investment options to choose from.

The good news, though, is that tough conditions have highlighted which managers are the best at playing a solid defense. With S&P and Moody's heading back to the drawing board to reevaluate their ratings methodologies--not to mention weakness in the housing market taking its toll on local economies nationwide--investing with teams that focus on the fundamentals is more important than ever. What's more, all the confusion has created rare pockets of opportunity among beaten-down insured bonds in instances where the market is neglecting a bond's underlying strength. We think the same teams mentioned above are well equipped to uncover them.