Updating Municipal Bonds and Bond Insurance

A few months ago (“Latest Bond Insurer Downgrades Should Not Trouble SNW AM Clients”, June 2008) we wrote about the credit difficulties besetting municipal bond insurers and why they were not of concern to SNW Asset Management clients because of our focus on the underlying credit quality of the municipal bonds which we purchase for their portfolios. In the months since that comment was written, the municipal bond insurance industry has been ravaged by additional downgrades in credit ratings.   Only one firm, Berkshire Hathaway, remains a consensus triple-A. Moody’s has dropped FSA to Aa3; AMBAC, Assured Guaranty, MBIA, Radian, and XLCA are at medium-investment-grade (single-A/triple-B) levels; and ACA and FGIC have fallen below investment-grade status altogether. This situation clearly supports understanding the issuer’s ability to repay its obligations without bond insurance.

Meanwhile, yields on U.S. Treasury securities have dropped to Depression-era levels, reflecting investors’ demand for safety at any price as economic indicators continue to point towards the worst recession in post-war history.  A flight to quality is no better illustrated than by the fact that the yield on 3 month t-bills actually dipped below zero for the first time ever.  In essence, investors are paying the federal government to hold their money for safe keeping.  The flight to quality has caused every fixed income asset class to reach historic wide spreads versus Treasuries.  Agencies, mortgages, corporates, and municipal securities are offering relative yields at or near historic highs versus Treasuries.  Fear in the market has created excellent opportunities for investors who are willing to be patient to ride out the current economic downturn. For example, many securities issued by municipalities that have strong liquidity profiles and which have shown fiscal discipline are offering attractive yields.

The portfolio managers at SNW Asset Management continue to believe that with careful selection of credits and a disciplined insistence on control of investment maturities, we can construct and manage portfolios that produce competitive levels of income and also provide reasonable stability of market value. The performance of our portfolios in 2008 is a case in point. After weathering a bit of panic pricing in September, our portfolios have shown an impressive ability to retain their market value despite all the headline risk about the potential impact of the faltering economy on municipal finances.

In the economic environment which lies ahead, some municipal credits will clearly do better than others. We make it our business to know which are which. Up to this point, unfortunately, credit selection for many investors and their advisors has been limited to the question “Are the bonds insured?” At SNW Asset Management, we have always looked instead at the underlying credit characteristics of every bond we have bought for clients. That is why our clients can now rest easy about their municipal bond investments and – more importantly – use available cash to seize this opportunity to add high-quality investments at what are very attractive cyclical spreads versus comparably-maturing U.S. Treasury securities.