If you own high quality municipal bonds the chances are that you own at least some that are "insured" bonds. For those not familiar with this feature, bond insurance is basically just a promise to pay that is provided by a special purpose insurance company. This promise is often added to municipal bonds to provide the bond issuer with a better rating (usually AAA) and therefore lower interest cost. Up until recently the health of these bond insurers was a non-issue. Today, however, we are discovering that several of these insurers themselves may have credit issues that could potentially impact the value of your insured muni bonds. If you own some of these insured issues what should you do?

Keep your perspective: So far the discussion surrounding the weaker bond insurers is mostly about a potential credit rating downgrade, not a default. Insurers are mostly, by definition, AAA rated credits so they will have a long way to fall before you have to worry about their promise to pay being worthless. Also, their businesses are attractive and generate enormous cash flows so they have considerable options in maintaining good financial health.

This is not just about the insurer: Remember that the insurers are only a backstop and there are issuers behind these bonds that have the first obligation to pay. The health of the insurer is largely secondary to the health if the municipal entity that issued the bonds in the first place. Fortunately, the incidence of actual default by municipalities is extremely low.

Downgrades themselves are not the end of the world: If you are a buy and hold bond investor ratings are not very important as long as the bond issuer continues to make its payments. Take comfort in the fact that the vast majority of municipal bonds are backed by either the taxing ability and/or revenue streams from essential services that the municipalities provide. When all is said and done, as a bond holder you are happy if you get the interest and principal you are owed when you are owed it. As long as you get paid all the rest of the discussion is basically just noise.

If you are still nervous make some adjustments to your portfolio: While I personally believe the default risk of insured muni bonds is extraordinarily low, you may still prefer to make adjustments to your muni bond portfolio to lessen your potential risk. First, own the strongest underlying credits and stick with issuers that provide critical services. Municipal providers of water, sewers, and the like will always have paying customers and therefore are relatively unlikely to default. More obscure issuers like small dormitory authorities and small town convention centers could have more trouble in a rough economy. Second, stick with shorter maturities as all else being equal they carry less inherent credit risk than longer term bonds. Finally, be sure your bonds aren’t all backed by the same insurer. While it may be preferable to avoid the insurers that are in the news, you still don’t want a huge part of your portfolio concentrated under the umbrella of just one company. The rules of good diversity apply here just as they do in other areas of your investing.

Remember that the underpinnings of the municipal bond markets are critical to the continued operations of literally thousands of municipalities across the country. The ability of the municipal bond issuers to make good their promise to pay means more than just repaying your bond, it means the ability of the municipalities to continue to operate. As you review your portfolio of insured municipal bonds, don’t panic, use the same disciplines of common sense and diversification you use elsewhere in your portfolio, and you should be fine.

Randy Gridley

November, 2007