Shaken by the Orange County bankruptcy filing, bond investors are shopping for safety.
"They're scared to death," said James Gammon, president of Lebenthal Asset Management in New York, which manages municipal bond portfolios for wealthy individuals, mainly in the Northeast.
Experts expect investors to focus on cutting risk instead of maximizing yields, which could be good news for the bond insurance industry.
"I think that the Orange County bankruptcy works to the long-term benefit of the insurers," said analyst Gary Ransom of Conning & Co. in Hartford, Conn.
But the industry, which guarantees 38% of the nation's $1.3 trillion in municipal bonds outstanding today, could also face losses among bond issuers squeezed by Orange County's filing for bankruptcy protection Dec. 6 under Chapter 9 of the U.S. Bankruptcy Code.
The two biggest players, Municipal Bond Investors Assurance Corp. and Ambac Indemnity Corp., which together control two-thirds of the market, said in separate announcements this week that they face a worst-case annual debt service totaling nearly $200 million from bond issuers that participated in the bankrupt Orange County investment fund.
But the insurers stressed that those kinds of payouts would come only in the highly unlikely event that every one of the 38 issues insured by MBIA and the 21 insured by Ambac with Orange County exposure goes into default.
MBIA, with an annual debt service exposure of $127 million, announced that it does not expect any losses. Ambac--with an annual exposure of $72 million, including $17 million from bonds issued by Orange County directly--was more circumspect but said it expects "any default to be temporary" and that it expects "ultimately to receive full recovery of any payments made."
Wall Street bought those reassurances--and the stock.
After dipping to $49.125 on the day of the Orange County filing, MBIA has since bounced back strongly, closing at $55.25 on Thursday, up $1.25 in trading on the New York Stock Exchange. Similarly, Ambac fell to $31 last week but closed at $35 on Thursday, up $1 on the NYSE.
Bond insurance enables municipalities with credit ratings of A to obtain AAA ratings on their bonds. Since AAA bonds pay lower interest rates than A--a trade-off that investors make in exchange for the additional safety--a community can save money on interest payments by buying the insurance. (That is, of course, as long as the insurance premiums are smaller than the difference in interest payments.)
Since 1987, the insured segment of the municipal bond market has doubled, to 38% from 19%. The dollar volume of insured bonds has also exploded, with more than $100 billion issued last year.
With all that supply, issuers of insured bonds have been forced to tweak their rates upward a little to attract buyers. That narrowed the "spread" between AAA insureds and uninsured AA or A bonds.
But evidence is starting to emerge that the Orange County crisis has caused investors to rediscover the value of insurance. Portfolio managers say increased demand is raising prices--and reducing yields--for insured bonds compared to uninsured bonds.
Just before Orange County's filing, yields on insured bonds were only 0.15 to 0.25 percentage points below those on some good-quality uninsured New York bonds, Lebenthal's Gammon said.
For example, a $100,000 insured bond yielding 5% would pay $5,000 a year, whereas a good uninsured bond might yield 5.15% and pay $5,150 a year. The $150 a year the investor sacrifices is a small price for security on a $100,000 investment, Gammon says.
Investors are starting to feel the same way, he said, because investor demand has grown since Dec. 6, causing the spreads between insured and uninsured bonds to widen to 0.40 percentage points.
"Investors are not going to take this kind of risk any more," he said. "It doesn't make sense."
Not all observers have seen such dramatic effects yet.
Don Duerson, who runs Franklin Group's $1.36-billion California Insured Tax-Free Fund, the largest mutual fund investing exclusively in insured California municipal bonds, said he has seen only a tiny increase in investment in his fund.
"It hasn't been what you'd expect, but we're hoping," he said.
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THE BOND INSURANCE MARKET
The bond insurance industry may benefit from the crisis in Orange County, as investors look for additional security.
Based on dollar volume for the first nine months of 1994: Insurer: Market Share (%)
Municipal Bond Investors Assurance Corp.: 41.1 AMBAC Indemnity Corp.: 26.7 Financial Guaranty Insurance Corp.: 22.3 Financial Security Assurance Inc.: 5.2 Capital Guaranty Insurance Co.: 2.7 Others: 2.0
Source: The Bond Buyer
Percentage of municipal bonds that are insured:
Source: AMBAC Indemnity Co.
* First nine months