Should You Be Concerned About Municipal Insurance Downgrades

Copyright 2008 ProQuest Information and LearningAll Rights ReservedCopyright 2008 Bank News, Inc. Bank News

September 2008

INVESTMENTS; Pg. 38 Vol. 108 No. 9 ISSN: 0005-5123

10625

721 words


Should You Be Concerned About Municipal Insurance Downgrades?

Kiefer, Joshua.

Joshua Kiefer is investment officer in the capital markets group of Country Club Bank, Prairie Village, Kan.



For decades, bond insurers have collected substantial premiums from municipal bond issuers and paid out little to municipal bond investors. Unfortunately, the abundant and steady premium revenue led to some poor investment decisions and the resulting loss of the insurers' triple-A credit rating. High-grade bond investors who relied on the insurers' formerly pristine imprimatur have been adversely impacted. As downgrades came and investors indiscriminately backed away, portfolio values fell. In the aftermath, a few questions are worth consideration: Should the downgraded bonds be sold? Should bond portfolios have an insured bond limit? Should investors avoid the muni market altogether?

The answers: No, no and no.

When buying insured municipal bonds, rule #1 is: The underlying and primary source of payment (ie: the issuer) must pass credit analysis on its own merit. This is a simple analysis that should be periodically performed as issuers publish current financial statements (which they are required to do with the issuance of new debt). While general obligation and revenue debt require familiarity with separate metrics, both are simple to appraise.

When analyzing GO bonds, investors want to determine whether the debt of an issuer is manageable compared to the property values, population, income and similar demographic data. This analysis commonly employs a number of debt ratios, which are compared to benchmarks based on regional or national averages.

The most widely referenced ratio is the net direct/ overlapping debt to assessed valuation. A common benchmark historically for this relationship has been in the 20 percent to 30 percent range or less.

Another measure of the level of indebtedness is the net direct/overlapping debt per capita. While a $3,000 debt per capita standard has been used, the same reasoning as mentioned above applies to growing areas. Be aware that assessed valuation as a percentage of actual valuation can vary from state to state.

It is also important to scrutinize the economic viability of the community along with the debt burden of the issuer. Is the tax base increasing or decreasing? Is the municipality dependent on one industry or well diversified? Is the population trending up or down? Will the municipality be able to raise additional taxes if necessary to pay principal and interest? These and related questions should be addressed before purchasing a bond, especially if the bond is non-rated or has a low rating due to a bond insurer.

Revenue bonds require a more extensive analysis. The primary objective is to determine whether the stream of revenue for the project is sufficient to retire the debt. It's important to know the purpose of the project, the economic stability supporting the project, the historical revenues generated by the project (if any) and the projected revenues.

Much like the analysis of GO debt, certain ratios serve as a benchmark for revenue bonds. The most important of these ratios is debt service coverage. This is defined as net revenues divided by principal and interest required for the year. For essential purpose revenue bonds (ie: utility bonds), a reasonable benchmark is a ratio of 1.25 times or greater coverage. Logically, investors should require a higher degree of coverage for projects with a more volatile stream of revenues. The maximum and minimum debt coverage ratios, based on historical and projected revenues should be considered. Investors should confirm that there are covenants in place stating that the issuer will maintain rates and fees sufficient enough to cover annual debt service, as well as a minimum coverage ratio.

The uncertainty of today's markets requires more than a superficial analysis of municipal credits. Against the current backdrop of non-differentiated selling of insured munis, this analysis will illuminate terrific values in the muni market. Due to an association with weak insurers, there have rarely been so many solid municipal credits so unfairly judged and terribly misunderstood by so large a trading population. In many cases, insured bonds are now trading at significant discounts to similar bonds with the same underlying credit, but without insurance.

Insured or not, bond buyers should look to the underlying credit at the time of purchase and periodically over the life of the bond.

February 9, 2009

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