Time to Think the Unthinkable About Bond Insurers

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Gekko
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Time to Think the Unthinkable About Bond Insurers

Post by Gekko »

Time to Think the Unthinkable About Bond Insurers: Joe Mysak

By Joe Mysak

Nov. 6 (Bloomberg) -- Let's think about life after bond insurance.

For years, institutional investors have always told you to study the underlying credit of the municipal bonds you buy, even if they are insured. After last week, now you know why.

The stocks of the two biggest bond insurers, MBIA Inc. and Ambac Financial Group Inc., plummeted as investors worried that the two firms' exposure to failing mortgages might cost them their AAA credit ratings.

http://www.bloomberg.com/apps/news?pid= ... lTr.hZWskM
Levett
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Post by Levett »

There was some evidence in the MUNI bond market today that fear came into play. Bob U.
larryswedroe
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Post by larryswedroe »

this is a serious issue

The insurers while still keeping their rating are trading as real junk, with one of the MI insurers trading at close to 1000bp over treauries-

Now who do you believe? The Rating agencies or the market?

Now the insurers likely to get downgraded which means the bonds will get downgraded--leading to sales (many institutions have quality restrictions)

Which is why it is so important IMO to have the right policies in place--for example I recommend not buying any muni that is not at least A rated without insurance that is anything more than very short term, and at least AA if long term at all, say more than 2 or 3 years. And another reason to avoid funds if have enough cash to buy on own. That way you control the credit risk

The subprime mess is long way from being over IMO.
grok87
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Radian

Post by grok87 »

Larry,
Looks like you're talking about Radian (2011 maturity) which traded at a yield of 14.9% yesterday. Pretty amazing.

It seems like the thing to do would be to avoid all insured bonds. Otherwise one will get caught in the downdraft of forced selling when institutions sell on the downgrades. Of course the contagion might spill over into un-insured bonds as well.

Should be some interesting times ahead. I wonder what the credit default swaps for the bond insurers are trading at. Often they are more dramatic than the bonds themselves...

cheers
grok
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Murray Boyd
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Post by Murray Boyd »

Could this really amount to more than a few basis points of return for a fund like Vanguard's Intermediate Tax-Exempt?
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tfb
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Post by tfb »

I'd like to point out that this issue primarily applies to Muni bonds. Correct me if I'm wrong. I think taxable bonds generally don't have insurance. So if you don't have muni bonds or muni bond funds, don't worry about it.
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craigr
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Post by craigr »

tfb wrote:Correct me if I'm wrong. I think taxable bonds generally don't have insurance.
Federal bonds have two types of primary insurance:

1) They can tax citizens more to pay bond holders.
2) They can print money to pay bond holders.

Usually it's a combination of both.

:)
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Post by Grt2bOutdoors »

larryswedroe wrote:this is a serious issue


The subprime mess is long way from being over IMO.

You got that right!!!
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Post by larryswedroe »

I would not avoid all insured bonds--that is going too far--the issue is what the underlying rating is.
A AAA that is a natural AA is probably still a very safe bond, especially if it is relatively short term and not a "sector bond" like a health care bond where default rates can be pretty high

But this is not only munis of course--it is MBS that are not GNMAs, especially private label (non-fnma/freddie).
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Post by grok87 »

larryswedroe wrote:I would not avoid all insured bonds--that is going too far--the issue is what the underlying rating is.
A AAA that is a natural AA is probably still a very safe bond, especially if it is relatively short term and not a "sector bond" like a health care bond where default rates can be pretty high

But this is not only munis of course--it is MBS that are not GNMAs, especially private label (non-fnma/freddie).
Larry,
I agree from a credit perspective. But I was really picking up on your point that there will be forced selling by institutions of insured bonds once the bond insurers are downgraded. Why would I want to take that risk with an insured bond when uninsured bonds are available (unless the compensation for the risk is good).

cheers
grok
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Gekko
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Post by Gekko »

should current holders of VG municipal bond funds have any worries?
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Post by bearcat98 »

grok87 wrote:Why would I want to take that risk with an insured bond when uninsured bonds are available (unless the compensation for the risk is good).
I don't know a lot about the muni bond market, and this is probably a silly question, but why would an insured bond be riskier than an uninsured bond? Even if the insurance isn't reliable, I'd think it would still be a plus rather than a minus, even if a very small one.

Just curious.
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austinite
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rating without insurance

Post by austinite »

How does one find the rating without insurance? I have not seen this type of rating from the usual rating sources.

Thanks in advance.
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Post by MossySF »

bearcat98 wrote:I don't know a lot about the muni bond market, and this is probably a silly question, but why would an insured bond be riskier than an uninsured bond? Even if the insurance isn't reliable, I'd think it would still be a plus rather than a minus, even if a very small one.

Just curious.
Compare:

Bond 1 - rated AAA w/o insurance
Bond 2 - rated AAA w/ insurance
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Post by larryswedroe »

grok
I agree there is certainly some risk---and this is one of the advantages of owning individual bonds and not a fund

Keep in mind though the costs of trading out of an individual bond for most individuals is likely to be fairly expensive. That cost has to be considered in any switching strategy

But I hope this thread helps people with future buying decisions
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Post by matt »

What is the bigger issue here, whether your munis get sold off due to downgrades, or the devastating recession that will occur if the problems at the bond insurers are as big as the market believes?
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Schooly D
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Post by Schooly D »

larryswedroe wrote:this is a serious issue

The insurers while still keeping their rating are trading as real junk, with one of the MI insurers trading at close to 1000bp over treauries-

Now who do you believe? The Rating agencies or the market?

. . .

The subprime mess is long way from being over IMO.
I've been watching what's been happening to the share price of the major reinsurance companies, more as a curious spectator than as an investor. The fifth largest of these players is Security Capital Assurance (SCA), which went public only last year after being spun off from XL Capital. The price of its shares is down 75% from a high of ~35 last spring.

Their recent quarterly earnings report stated that they took a mega million dollar unrealized loss based on GAAP mark-to market accounting, but that using non-GAAP measures their earnings are growing year-over-year and they have minimal exposure to the sub-prime mess. Sounds fishy, and I don't understand enough about corporate finance to know whether GAAP or non-GAAP measures of profitability are more valid, but company insiders have been purchasing bucketloads of their own shares and the securities analysts who cover this company all have a buy or hold recommendation.

So does the market know something that the company insiders and security analysts don't?

David
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Post by jh »

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Post by jh »

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Post by larryswedroe »

Every bond is different

Many are double AA underlying and AAA with insurance. The reason is they buy the insurance is the companies were almost giving it away--cost was just a few basis points--and they pick up in yield reduction exceeded it (reason is you gain investors who will only by mandate by AAA). Those bonds not likely to get hit much, especially if short term---though likely will get hit some of course.

It is the bonds with lower underlying ratings and longer term that could get hit a lot.

Again, another benefit of buying individual bonds is you control the credit risk!!!
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Post by Sphinx »

Gekko wrote:should current holders of VG municipal bond funds have any worries?
I'm curious about this, too. The average quality of most of Vanguard's Tax-Exempt bond funds is AA+. One of them averages AAA (Vanguard Insured Long-Term Tax-Exempt Fund), and one has an average quality as low as A+ (Vanguard High-Yield Tax-Exempt Fund).

If the average quality of a municipal bond fund is AA+ or higher, is it OK to invest in it?

:?:
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Post by larryswedroe »

sphinx
The issue is about what the UNDERLYING rating is without the insurance--that you would have to dig into each issue they own to learn
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Post by brainstem »

Folks...
This topic came up in August and it was pointed out that funds diversify your risk --- the insurance game is usually not the main selling point for the bonds in the first place -- if the insurers go belly up, it would take a lot of muni defaults to hit hard in a diversified mutual fund
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?? Good time to buy some CEFs???

Post by btenny »

With all this selling of good bonds and bond insurers I see really large discounts in CEF funds like NVG and other AAA rated bond funds. Today NVG is selling at $13.35 which is over 10% discount from the $15 price of the underlying bonds. Plus the bonds are all AAA rated and insured. So is this a good time to buy. It seeems to be a good buy to me.....

Bill
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Post by larryswedroe »

btenny
They may be AAA because of the insurance--but not AAA without them

Big difference
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Re: ?? Good time to buy some CEFs???

Post by stratton »

btenny wrote:With all this selling of good bonds and bond insurers I see really large discounts in CEF funds like NVG and other AAA rated bond funds. Today NVG is selling at $13.35 which is over 10% discount from the $15 price of the underlying bonds. Plus the bonds are all AAA rated and insured. So is this a good time to buy. It seeems to be a good buy to me.....
Muni CEFs have a tendency to be long term (20 years) and leveraged. So you get whiplash every time interest rates change due to volatility.

Paul
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Post by Paladin »

larryswedroe wrote:sphinx
The issue is about what the UNDERLYING rating is without the insurance--that you would have to dig into each issue they own to learn
Larry,

I think this is rather impractical for many (most?) of us on this forum.

- Paladin
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Post by larryswedroe »

paladin
I agree, but it should be pointed out anyway

Larry
Paladin

Post by Paladin »

larryswedroe wrote:paladin
I agree, but it should be pointed out anyway

Larry
Agreed Larry.

I don't want folks to think that they somehow should be analyzing the whole portfolio of bonds in a Vanguard muni fund.

- Paladin
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Post by Valuethinker »

bearcat98 wrote:
grok87 wrote:Why would I want to take that risk with an insured bond when uninsured bonds are available (unless the compensation for the risk is good).
I don't know a lot about the muni bond market, and this is probably a silly question, but why would an insured bond be riskier than an uninsured bond? Even if the insurance isn't reliable, I'd think it would still be a plus rather than a minus, even if a very small one.

Just curious.
Uninsured bond - rating is 'natural' a direct assessment of the risk rating of that municipality or public project

insured bond - rating is 'artificial' in the sense that it is the credit rating of the insurer

So if the muni bond insurers are downgraded far enough, it becomes the 'natural' credit rating of the insured bond which counts. And since you normally only insure a bond to get a higher rating (and lower funding cost) that's likely to mean yields are higher/ prices are lower.

An insured bond therefore has a lower 'natural' credit rating, and so is riskier than an uninsured bond.

But in practice, at least according to Larry, there are few municipal bond defaults-- states and municipalities raise taxes, tolls, cut spending etc rather than default and ruin their credit rating forever.

Some states bear watching: Michigan? with a collapsing industrial base. Other states are overly dependent on eg transaction revenues from real estate. But generally States solve their fiscal problems, rather than going bust.
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Post by matt »

Valuethinker wrote:
But in practice, at least according to Larry, there are few municipal bond defaults-- states and municipalities raise taxes, tolls, cut spending etc rather than default and ruin their credit rating forever.
This is true. Using the bond insurance is usually the municipality's last resort.

Nonetheless, that does not mean that the insurance is unimportant. Who will want to provide funding to a medium-grade muni bond from a small county in Idaho that you've never heard of? Those who are willing will certainly demand a higher interest rate than what they have been asking for the insured debt. Even now, the cost of insuring debt has gone up due to the current credit problems.

That is why the repercussions could be quite severe, in the short run, at least, if a major insurer like Ambac loses the confidence of investors. In the long run, of course, others would eventually step in and things would get worked out, but not without some pain.

Of course, this argues that maybe Ambac is too big to fail. But the list of companies that are having trouble and are supposedly "too big to fail" is getting so big that bailing them all out would equate to a conversion to a socialist economy. I'd rather just have a tough recession where hopefully a few lessons about risk management will be learned. But I'm not running for political office or influenced in that regard; if I were, I'd just say "cut Fed Funds to 1% and let's do it all over again!"
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Post by larryswedroe »

"But in practice, at least according to Larry, there are few municipal bond defaults-- states and municipalities raise taxes, tolls, cut spending etc rather than default and ruin their credit rating forever."

NOT TRUE--I never said that. What I did say is that there are sectors within the muni world that have VERY HIGH DEFAULT RATES and should be avoided.

Now if buy AAA and GO bonds then almost certainly will not default
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Post by Gekko »

i think i heard the author of this article say that municipal bonds have a less than 1% risk of default.
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Post by Rick Ferri »

.
I have been managing municipal bond portfolios for almost 20 years. There is one rule of thumb I that have always lived by; Don't buy insured bonds for the insurance. Buy municipal bonds based on their underlying credit quality. If the bond has insurance, that is a bonus.

Rick Ferri
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Gekko
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Post by Gekko »

i'm confident that VG bond fund managers are on top of it.
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More data

Post by btenny »

I could not find underlying bond ratings for the NVG fund but maybe I don't know how to read all the data. Basically most of the bonds are rated AAA or there abouts by Fitch or Moodys but as you guys have pointed out this may be after insurance or it may be the raw bonds. What I do find is that 30% of the bonds are pre-funded and another 30% (?? overlap) are government guranteed and another 13% are general obligation bonds. So depending on how you interpret this data I see a pretty good risk mix.

Yes the fund is leveraged so the fund price does wipsaw somewhat with the market and yes the bonds are longer term but so are Vanguard Intermediate bond funds. So those Vanguard bond funds wipsaw around in price also. Plus this particular fund is really sale priced right now and yields way more than a similar taxable Vanguard fund...

Bill...
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Post by Valuethinker »

larryswedroe wrote:"But in practice, at least according to Larry, there are few municipal bond defaults-- states and municipalities raise taxes, tolls, cut spending etc rather than default and ruin their credit rating forever."

NOT TRUE--I never said that. What I did say is that there are sectors within the muni world that have VERY HIGH DEFAULT RATES and should be avoided.

Now if buy AAA and GO bonds then almost certainly will not default
My apologies for misquoting you.

Which are the sub sectors with very high default rates? (better yet, is there a link to the historic data, somewhere?).
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Post by Valuethinker »

matt wrote:Valuethinker wrote:
But in practice, at least according to Larry, there are few municipal bond defaults-- states and municipalities raise taxes, tolls, cut spending etc rather than default and ruin their credit rating forever.
This is true. Using the bond insurance is usually the municipality's last resort.

Nonetheless, that does not mean that the insurance is unimportant. Who will want to provide funding to a medium-grade muni bond from a small county in Idaho that you've never heard of? Those who are willing will certainly demand a higher interest rate than what they have been asking for the insured debt. Even now, the cost of insuring debt has gone up due to the current credit problems.

That is why the repercussions could be quite severe, in the short run, at least, if a major insurer like Ambac loses the confidence of investors. In the long run, of course, others would eventually step in and things would get worked out, but not without some pain.

Of course, this argues that maybe Ambac is too big to fail. But the list of companies that are having trouble and are supposedly "too big to fail" is getting so big that bailing them all out would equate to a conversion to a socialist economy. I'd rather just have a tough recession where hopefully a few lessons about risk management will be learned. But I'm not running for political office or influenced in that regard; if I were, I'd just say "cut Fed Funds to 1% and let's do it all over again!"
Tough recessions have a way of spiralling out of control and bringing down people and businesses who were not imprudent.

The importance of 'animal spirits' in all this is huge: companies make investment and hiring decisions on a finger in the wind appraisal of business conditions. When that turns down, a lot of people get hurt.

The 'corrective' that is inevitably called for by a certain stripe of market commentator (see the kinds of things said post the Crash of 1929) inevitably ignores the collateral damage: small businesses having their credit line pulled, collapse of residential neighbourhoods, etc.

The best the monetary authorities can do is pay due regard to inflation in making their decisions. And to moving swiftly as possible to cleaning up financial messes.
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Post by larryswedroe »

valuethinker
Housing
Health Care
Industrial Development

We avoid those three sectors when building portfolios
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