This commentary was written by John Mousseau.  He heads Cumberland’s tax-exempt fixed income area and is a long time veteran of tax-exempt fixed income markets.  His bio may be found at www.cumber.com.  Comments on this article may be directed to john.mousseau@cumber.com.

The beginning of this year has gotten off to a very rocky start in the municipal bond world.  We see continued focus on the municipal bond insurers and their exposure to the subprime mortgage product derivates that they have insured. 

FGIC and AMBAC have experienced downgrades in their claims paying ability.  They are now rated AA instead of AAA by Fitch Rating Services.  XCLA has seen its rating dropped to A by Fitch.  All three still have AAA ratings from Moody’s and Standard and Poor’s although these ratings are on “negative” watch for possible downgrade.

All this means that the scrutiny on underlying ratings which began late last year has continued and intensified.  Certainly many bonds that are FGIC, AMBAC, or XCLA insured are trading as if the insurance was not there.

This has created consternation both in the short maturity end and the long maturity end of the municipal bond market.  These are related.  They have created what we think are opportunities in both ends of the maturity spectrum for insured bonds. We are going to limit our discussion to bonds insured by AMBAC, FGIC, and XCLA.  Bonds insured by MBIA are under slightly less pressure although MBIA has subprime insurance exposure.  FSA has had much smaller exposure and is trading “richer” in the market.

Long-term Insured bonds.

Many of the large “blocks” of long insured 5% coupon bonds were bonds purchased by tender option bond programs (TOBS).  These programs are used in some bond funds, hedge funds and some private accounts.  They leverage these block purchases by selling short term paper secured by a claim on the block.  Much of this paper is bought by money market and short term funds on an auction rate basis. 

With the problems facing the bond insurers, the money market funds have balked at owning short term paper backed by the “bad 3” of the insurers. The Muni money market funds are very risk averse, even more so given the problems of their taxable money market brethren.  Thus the TOBS have experienced some failed auctions of their short term paper and been forced to buy it back.  Thus the “blocks” are reconstituted and then thrown on the market.  This has forced the yield up on many of these long term bonds to levels above 5%.

We think these are attractive for a number of reasons. 

First, at cheaper than 5% yields in the long maturity range (30 years) they compare at 50 basis points cheaper than high grade paper and 40 basis points cheaper than other insured bonds (FSA, MBIA).  This also compares to a 4.35% rate on the 30 year US Treasury bond. (115%+)

Secondly, most of these FGIC, AMBAC and XCLA insured bonds have issuers whose underlying rating is A or BBB; they are either general obligation or essential service revenue bonds.  The bonds are trading as if the insurance did not exist.  We feel that these problems at the insurers will be addressed with additional private capital or perhaps a quasi-private governmental partnership to provide a capital infusion. 

There is also the chance that they get downgraded to below AAA status.  S&P downgraded FGIC on Thursday, Jan 31st.  This clearly would change their business model but it would not change the intrinsic or underlying value of these bonds, especially from the current cheap levels that are trading in the market. 

We must stress that these cheap 5% insured coupons are not available in all states. For example, there have been very few bonds of this sort in New Jersey.  The one that we examined had structural issues that caused us to reject it even though the yield was above 5%.  Investors MUST do their homework on these securities’ technical structure and on the underlying credit.  Otherwise they are looking for trouble.

There is another wild card potential for upside with these bonds.  That occurs because many of these bonds have cheaper original issue yields and are refundable in a lower interest rate environment.  It is conceivable that an issuer could come to market with a stronger insurer (e.g. FSA or the new Buffett insurer) and pre-refund this older, higher coupon debt at a much lower rate.  The upside potential from pre-refunding is as much as 10-to-13 points from current levels.

Floating Rate Bonds

Many of the tax exempt” floating rate bonds which carry insurance from AMBAC, FGIC, and XCLA are now trading in the 6% plus range.  Many of these have investment grade underlying ratings and liquidity agreements with various banks.  These bonds may be daily, weekly, bi-weekly 28-day or 35-day resets depending on the mode of the floater. 

The rationale for the money market funds “putting” these issues back is similar to their refusal to own the auction rate derivatives of the TOBS programs.  They would rather not have any exposure to these insurers.  So they putting back these insured floaters and buying other insured floaters. 

These floaters, because of the put feature, trade at par so the “clearing” mechanism is in the daily, weekly, or monthly yield.  As the dealers have become “clogged up” with these floaters, the yields have risen from the low 3% area to 6% or higher.  The liquidity feature of these floaters can often be removed in the case of outright defaults or downgrades of insurers below certain levels.  These features differ on an issue to issue basis.  However, considering that 6% tax-free is about a 10% taxable equivalent for what is a near-zero duration, we feel there is a compelling case to be made for owning some of these floaters.  Again we stress that an investor MUST do the homework on each bond.

There are certain details to examine:  (1) Many of these floaters have rate ceilings such as 10-12%. Clearly at these higher levels (or lower) issuers would call these bonds and issue long term fixed rate debt.  (2) If the capital deficiency problems are resolved, the rates on these floaters will quickly return to lower levels.  This will remove the attractiveness and the reason to own them versus other floaters.  (3) We do not know how long these high interest rates on floaters will last; it could be only a few weeks or, perhaps, many months.  Thus we are following our positions daily.

The problems of the bond insurers will continue to evolve.  We do know that the amount of defaults in subprime mortgages and Collateralized Debt Obligations that have defaulted with insured coverage is very small.  The amount of capital the rating agencies are asking the bond insurers to post is very large.  We have seen the entry of Warren Buffett into the world of bond insurance which to us signifies a still viable business.  And we know that the default rate on MUNICIPAL obligations is very small which is why the bond insurers like to write municipal bond insurance on a near-zero loss rate.

Meanwhile, the barbell of the troubled insurers, 6% floaters and 5% long bonds are attractive to us.  Especially when we compare them against a 2.10% 2-year Treasury note and 4.35% 30-year Treasury bond.