Uninsured Doesn't Mean Unsafe

By Jane Bryant Quinn
Sunday, May 11, 2008

Now you know. You've been wasting your money by buying insured municipal bonds. The bonds themselves are fine. In fact, muni yields are practically irresistible today, for taxable accounts. The wasteful part is the insurance. You don't need it and never did. The bonds themselves are better, safer credits than the expensive insurance wrapped around them.

Municipal bond insurance provides investors with a guarantee. If the issuer defaults, the insurer will cover the interest and principal payments as they come due. This form of comfort comes at a price. Bonds from sound insurers yield about 0.2 to 0.3 percent less than similar bonds that are uninsured, said Jerry Webman, chief economist for OppenheimerFunds in New York.

The cost isn't worth it. Muni bonds hardly ever default. A recent study by Standard & Poor's of uninsured munis, issued by 10,268 borrowing entities since 1986, found zero defaults among those rated AAA and AA. Among the single A's, 0.16 percent defaulted, and among the BBBs, only 0.29 percent. That's a far better record than you see in quality corporate bonds.

Muni bond insurance entered the tax-exempt market to help municipalities improve their credit ratings. The insurers were all rated AAA. Cities and states with lower ratings could raise themselves to AAA by buying the insurers' guarantee. That reduced the interest rate they had to pay. Roughly half of all municipal issues are insured.

To retail investors, AAA insured bonds sound safer than uninsured AAs -- even though AA munis are historically safe. "It's purely emotional," said fee-only financial planner Jonathan Krasney of Krasney Financial in Brookside, N.J. "Investors are in many respects naive about underlying quality."

Besides, the insurers guarantee only bonds they think are safe. "Not having widespread insurance might be better for investors, because they'd get a higher yield on bonds that are secure anyway," Webman said.

Muni bonds are safer than the insurers that guarantee them and always have been. Two rating scales exist in the credit business: one for municipals and one for corporates. The standard for munis is a lot stiffer. For example, the state of California lies in the single-A range even though it has never defaulted on its debt. Corporates, where defaults are more common, are judged more leniently.

This double standard forces states, cities and towns to buy insurance on bond issues that ought to have won top ratings on their merits alone. It's a sweet deal for insurers and a crummy deal for taxpayers, who are paying billions of dollars in unnecessary interest and fees.

What's more, the leading bond insurers turned out to be worse credits than anyone imagined. They started issuing guarantees to high-risk securities based on subprime mortgages, got caught in the market collapse and have been scrambling for enough capital to keep themselves going.

Fitch Ratings Service has downgraded two insurers, Ambac Financial Group and MBIA from AAA to -- drumroll -- AA! Both companies maintain their prestigious AAAs at Moody's and Standard & Poor's. Ambac is in so much trouble that its stock fell from $96 last year to a recent low of about $3.50. Still, it's rated "stronger" than the entire state of California.

Starting this month, Moody's will give two ratings to municipals, if they ask for it: the lower muni rating and the higher "global" rating they would get if they were judged by the kinder standards used for corporate bonds. As an example, a muni backed by the taxing power of the government and normally rated A3 (Moody's seventh from the top) could rise to Aa1 (its second-highest rating), using the corporate-equivalent, or "global" scale.

Fitch says it's reviewing its corporate and municipal rating scales. S&P says it doesn't use two scales, which the states dispute. Even so, it has been upgrading munis in recent years. In 1986, only 20 percent of issues were rated AA or higher; last year, 33 percent were.

Occasionally, municipalities do default. Jefferson County, Ala., home to Birmingham, got flim-flammed by Wall Street's white-shoe types, invested heavily in exotic securities and now can't pay the interest due. It's talking bankruptcy, but rescue negotiations are under way. Its bonds are insured primarily by two companies, Financial Guaranty Insurance and XL Capital Assurance. They both have been downgraded substantially by all three rating companies.

The credit-market failures, plus the troubles of muni bond insurers, have driven the price of munis down and the yields up. They've become a huge buying opportunity for investors in tax-exempts. Ten-year AAA-rated bonds are now yielding an average of 3.86 percent, a tad more than comparable, taxable Treasury bonds.

For investors, however, buying individual bonds carries extra risk, even if they're insured. If you need cash and have to sell the bonds before maturity, you'll take a big haircut on the retail price.

Mutual funds are a better choice. You get decent diversification and your manager buys and sells the bonds at the institutional, wholesale price. Look for low annual costs, meaning less than 0.5 percent. Some munis get caught by the alternative minimum tax, so if you're in that bracket, choose a fund that's AMT-free. As for mutual funds that buy only bonds that are insured? Don't bother.

Jane Bryant Quinn, author of "Smart and Simple Financial Strategies for Busy People," is a Bloomberg News columnist. Alexis Leondis in New York contributed to this column.

© 2008 The Washington Post Company