Downgrading of bond insurers affects market

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SAN FRANCISCO -- These are uncertain times for investors in municipal bonds, which are loans to government entities.Many cities, states and other entities issue municipal bonds to finance schools, roads and other public projects. They're facing lower revenue as a result of the slowing economy, which could affect their ability to repay their bonds.The difficulty runs deeper: Insurance to safeguard against bond defaults has come into doubt as the companies that issued these insurance policies are having their own problems. The insurers' credit ratings have been cut.These ratings downgrades have caused the value of insured bonds to decline relative to uninsured bonds and have increased risk and uncertainty in the muni market.Most municipal bonds are purchased by higher-income individuals -- either directly or through mutual funds -- who can benefit from their tax-exempt income.The most significant downgrade happened a week ago, when Standard & Poor's lowered its ratings on Ambac Assurance Corp. and MBIA Insurance Corp. -- the two largest bond insurers -- to AA from AAA and placed them on credit watch negative, which means their ratings could get cut again within 90 days.Another rating agency, Fitch, lowered its ratings on the same two insurers earlier this year. Moody's still rates them AAA but last week put them on review for possible downgrade.Many smaller insurers have also had their ratings slashed.That leaves only two insurers -- Financial Security Assurance and Assured Guaranty -- with unanimous AAA ratings. Berkshire Hathaway's new bond insurance company also is rated AAA but hasn't done much business yet.Here are answers to some questions about muni bond insurance.Q: How does bond insurance work?A: Many issuers purchase insurance when they sell bonds. If the issuer can't repay its bonds, the insurer steps in and makes all interest payments and, upon maturity, the principal.The insurance does not protect investors against fluctuations in market value. If an investor sells insured bonds before maturity, there's no guarantee he or she won't lose money.Q: Why buy bond insurance?A: When issuers sell bonds, their credit rating helps determine what interest rate they will pay, the same way credit scores affect how much consumers pay for auto or home loans. In both cases, the lower the rating, the higher the interest rate.Issuers can usually reduce their interest rate if they buy insurance from a company with a higher credit rating. If a city is rated A, it generally pays a lower rate if it buys insurance from an insurance company rated AAA, the same way a consumer might get a better rate on an auto loan if he got a co-signer with a better credit rating. Until recently, virtually all bond insurers had AAA ratings.Issuers estimate how much they would pay with and without insurance and if the savings is greater than the cost of insurance, they buy it. An issuer might buy insurance on some bond issues and not on others.Over the past decade, roughly half of all municipal bonds issued were insured.Q: What went wrong?A: Bond insurers pursued a "zero-loss" underwriting standard, according to the Securities Industry and Financial Markets Association. By confirming that the issuers were so strong, the insurance companies believed that they would sustain no losses. By contrast, most property and casualty insurers assume they will face some losses. Most bond insurers in recent years ventured outside munis and started insuring bonds backed by subprime mortgages and other complex debt securities.When those markets collapsed, investors -- and rating agencies -- started to fear that the insurers would suffer losses that could jeopardize their ability to repay muni bonds.Q: What impact has this had on insured muni bonds?A: Early this year, when ratings started to fall, many investors simply refused to buy insured bonds. Their prices relative to uninsured bonds fell and their yields, which move in the opposite direction, started to rise. In some cases, insured bonds yielded more than similar bonds without insurance. Usually, they yield less.Today, investors are focusing on the issuer's underlying rating. Unless the bond is insured by one of the two firms that maintain solid AAA ratings, investors are essentially ignoring the insurance.Q: Where does this leave investors?A: If you own a wide variety of municipal bonds, or a muni bond fund, there's no need to panic.If you own individual bonds and hold them until maturity, they are still likely to pay off.If you need to sell at maturity, you could make or lose money depending not only on credit ratings but also on what has happened to interest rates since you purchased them.Now, more than ever, it's important to have diversification and professional management, either with a mutual fund or a broker who is well versed in municipal bonds.(E-mail Kathleen Pender at kpender(at)sfchronicle.com. For more stories visit scrippsnews.com)