The turmoil in the municipal market over bond insurers’ exposure to ill-fated products derived from subprime mortgages has continued, with recent downgrades of monoline insurers suffering from severe financial deficiencies. In addition, Democratic leaders are proposing federal oversight and uniform standards for insurers, and the affected guarantors are being closely scrutinized by the Senate Banking Committee and Treasury Secretary Henry Paulson.
In the last week, both Financial Guaranty Insurance Co. and XL Capital Assurance Inc. were downgraded by Fitch Ratings after failing to address capital shortfalls of $1 billion and $2 billion, respectively, that the rating agency said the companies would need to maintain their AAA status.
After giving the companies four to six weeks to come up with additional capital, FGIC was downgraded to AA from AAA on Thursday, while XL was downgraded to A from AAA a week ago Thursday. Both monolines remain on negative watch, according to Fitch. They join Ambac Assurance Corp., which is the only other triple-A insurer to be downgraded to AA by Fitch earlier this month.
The increased uncertainty over how and when subprime-related problems will be ironed out is triggering a buying opportunity in the municipal market — most notably a devaluation of insured paper as investors’ intense focus on underlying credit quality has caused a noticeable drop in the price of insured bonds affected by the downgraded guarantors.
Besides federal oversight and intervention, New York regulators led by state insurance superintendent Eric Dinallo are mulling several solutions, including a possible bailout that involves Wall Street banks providing emergency funds.
Until a resolution is reached, the higher yields are a welcome sight for many mutual fund managers, who say they are eager to uncover attractive bonds at a time when absolute yield levels in municipals are near historic lows and the Federal Reserve Board has recently cut the federal funds rate as a means of jump-starting the sluggish economy.
Fund managers weighed in this week with their observations and opinions about how the current situation is affecting the price and demand for insured paper, as well as strategies that they or other market participants are using to find value in the bond industry’s troubled situation.
TOM SPALDING, NUVEEN
Tom Spalding, vice president and senior investment officer at Nuveen Advisory Corp. who manages 12 portfolios totaling $10 billion.
“We’re looking at all aspects of the insured market. The market is the market. The most activity has been selling FGIC at something behind a 5% yield into retail, mutual funds, or property and casualty companies. That seems to be the one under the most pressure.”
“If you sell because you are afraid they will lose their triple-A rating, [across the board] there may be a whole wash of additional sellers of FGIC paper and that could cause further declines in the market.”
“It might be a little cheaper [going forward] and [even though] the underlying credit is acceptable, the theory is there will be more selling if Moody’s [Investors Service] and [Standard & Poor’s] downgrade. What’s now selling at a 5% might move to a 5.25% after a downgrade.”
“There was a little selling in XLCA Monday because they were downgraded to single-A by Fitch. The theory is Moody’s and [Standard & Poor’s] are also going to downgrade them sometime in the future also. If they lose their triple-A and go to single-A, they probably won’t be any worse than they are now, but this is maybe the best time to sell before any further downgrades.”
Financial Security Assurance “is trading the best … some people are selling a little of FSA. The theory is there is no upside on FSA because their ratings have been affirmed. That might be one to sell if you’d want to take on a little more risk on FGIC, MBIA [Insurance Corp.], or even Ambac.”
“You can sell FSA at a 4.40% or 4.50% yield, and buy FGIC behind a 5%. That’s quite a big pick-up in yield. And, if you think there is going to be a bailout on the others, it’s obviously a risky strategy, but some people are thinking of doing it for the additional yield and additional potential total return.”
“For most insured funds, your triple-A is based on when it was purchased. You may suffer a little deterioration because of a downgrade, but if you are comfortable with the underlying credit you might want to hold it for a longer term rather than sell it, because long term, the bonds may perform better after a downgrade.”
“The insurance commissioner is working on a bailout of the insurance companies with the banks. That’s the upside of holding on. If you are forced to sell and you are highly levered, a weaker market might create more losses than the portfolio can take, and therefore, you might want to sell some of them now.”
CLARK WAGNER, FIRST INVESTORS
Clark Wagner, director of fixed income at First Investors Management who manages 19 insured municipal bond funds that total $1.45 billion, the largest of which is the First Investors Insured Tax-Exempt Fund, which totals $739 million.
“I am not reducing insured exposure, but I really can’t … It’s not an option because our funds can only hold insured bonds. We own $1.5 billion of insured bonds and we have a market weight in all the insurers. If I sell bonds, I would be in cash, so beyond that it doesn’t make sense to sell the insured bonds of the insurers under stress because the bonds are trading so cheaply.”
“We have been buying some bonds. It’s all a function of what’s out there and if you’re comfortable with the underlying ratings. The yields are over 5%. You have short-term muni bond yields close to 2%, so the chance to buy 5% in a decent credit in this interest rate environment is welcome.”
“I think in general, though, most real money managers are not selling at this point. Fund managers and insurance company managers are not looking to reduce their insured exposure at these levels. Three-quarters of insured bonds are trading based on their underlying credit — as if they were not insured — so there is no point of selling the bonds.”
“The market has fully discounted the value of insurance. After Fitch downgraded Ambac to double-A and XLCA to single-A, the market changed quite a bit in terms of where bonds were trading. It caused people to re-evaluate what they were going to pay for insured bonds.”
“It’s company by company … it’s a very fluid situation. The market has taken the worst-case view, which creates some potential upside if the ratings are affirmed at triple-A.”
“The tender-option bond programs are being forced to de-leverage because the money market piece of the tender-option bond program can’t be re-marketed at a rate that makes sense.”
“The TOB selling seems to be meeting with a fair amount of demand from other investors, like mutual funds and insurance companies.”
REID SMITH, VANGUARD
Reid Smith, principle and senior portfolio manager at Vanguard Group Inc. in Valley Forge, Pa., who manages six funds totaling $36 billion. The firm itself has over $50 billion in actively-managed municipal bond fund assets.
“As a bondholder, if I am buying or if I am selling, I am focusing on the underlying credit. At the end of the day, that’s what the bond is really worth.”
“We don’t want our vision clouded by the credit issues with the monolines. I don’t want to make a prediction one way or the other. Munis continue to represent a very high-quality asset class with very low default rates.”
“There is some dislocation where people are trying to de-leverage positions because there may be concentrations in certain insurers that are no longer able to be economically funded in the market.”
“There are some points of pressure there, and we are seeing some fairly cheap spreads.”
“We have a supply bulge created by people selling leveraged positions. In reducing exposure, there’s opportunity to pick through the credits.”
“If it’s a forced de-leveraged position and bonds trade at cheaper spreads than where the underlying bonds trade, that is a buying opportunity.”
“We focus on the spread for the underlying credit. We strip away the support of the monoline and focus on the underlying credit, and let that be the guide to our purchases.”
“There’s points of opportunity where people are forced to jettison bonds, and for those situations, there’s an additional requirement for liquidity, and that causes relative value for a long-term holder of debt.”
“Until this is resolved, the amount of issuance has dropped substantially and the new-issue market has gone into a dormancy stage. There are deals, like the Wisconsin clean water and the [San Francisco Airport Commission deal], which are getting postponed. Small issuers and large issuers have historically used insurance to improve the cost of borrowing, and some of them are being swept up by the uncertainty of this market.”
“A long-term solution is in the best interests of the market, but in lieu of that, we look to the underlying credit, which still is a very high-quality, highly valued credit. Our bias toward quality and our traditional focus on underlying credit has served us well in this market.”
DAN LOUGHGRAN, OPPENHEIMER
Dan Loughran, senior vice president and portfolio manager at OppenheimerFunds Inc. whose municipal bond team manages 18 tax-exempt portfolios totaling $33 billion.
“Being a yield-driven manager we tend to have, on average, fewer insured bonds as a percentage of our portfolios than most of our competitors. That’s in our favor because we have plenty of room to act on individual situations without being constrained and we have not been forced to sell anything.”
“There are some people that are selling out of fear that’s overblown or others selling because they have to. That just creates a buyer’s market and that’s the type of market that we like.” On the other hand, buying additional insured bonds “has not materially changed the make-up of our portfolios.”
“We’re looking at this as a buying opportunity to find situations where the underlying borrower is still a good credit and the bonds are cheaper because of the insurance policy.”
“The insurance policy is hurting the price of the bonds and making them cheaper than what the underlying borrower would trade at without any insurance. That seems irrational to me because even if you considered the insurance policy worthless in a worst-case scenario, having an insurance policy shouldn’t detract from the value of the bonds.”
“We’re seeing some situations like that, and we are selectively taking advantage of them.”
“This has been a condition that has existed for a few months and it’s been magnified now because of the increased fears of downgrades to the insurers.”
“Our strategy going forward is to focus on the underlying borrower and look for individual situations that are mispriced so that whether there is a bailout or not, we still have a bond that we bought at an attractive price.”
