With bond insurer ratings on the brink and hedge funds fresh off a selling spree, the normally staid municipal bond market has taken on a more volatile profile over the last few months. "There are going to be some good spots to step into the tax-exempt market over the next few months, but it will pay to be a little smarter about where you position yourself," says Matt Fabian, managing director at Municipal Market Advisors in Westport, Conn.
Fabian notes that slackened demand in the first half of the year could bring higher yields and more choices for investors. Widening credit spreads and fallout from the bond insurer debacle also present some opportunities for bargain hunting, he adds.

Today's environment is very different from last year's tamer times, when state and local governments sold a record $428 billion worth of bonds, about 5% ahead of the previous record of $408.3 billion set in 2005. Volume was particularly strong in the first half of the year as issuers took advantage of low long-term yields to sell new bonds and refund old ones. With investor demand strong, yield spreads between the highest-quality triple-A bonds and lower-rated ones narrowed and the yield curve stayed flat.

But a series of events that began in the fourth quarter raised the bond market's blood pressure. Rating agencies put several bond insurers with excessive subprime mortgage exposure on credit "watch lists," a harbinger that their triple-A ratings-the same treasured rating status conferred on the bonds they insure-are teetering dangerously close to a downgrade. Because these insurers have backed about half of all bonds sold in recent years, and guarantee payment of principal and interest on more than $2 trillion in debt, the impact reverberated in virtually every corner of the muni market. By January new issue volume had plunged 47% from the previous year and stood at its lowest level since September 2001.

As investors began trading the bonds based on their underlying credit ratings-rather than their insurance carrier's financial strength-prices on many insured bonds fell and yields rose. Another jolt came from hedge funds, which had large leveraged positions in municipal bonds, but began selling them to cover short positions in Treasury securities.

The woes of publicly-traded insurers spilled over into the stock market. On one day in mid-January alone, Ambac stock slid by 52% and MBIA shares fell 31% after Moody's and Standard & Poor's reiterated concerns about their financial stability. Press reports fingered bond insurer problems as one of the culprits behind the stock market's steep slide that month.

Experts say these events, along with fears of a continued economic slide, point to the likelihood that investors will need to use different tactics than they have in the past to keep a firm footing in the municipal bond market. Among the strategies they suggest:
Differentiate among bond insurance companies. In the past, municipal bond investors rarely questioned the financial stability of bond insurers, or differentiated among them. But with Ambac Assurance Corporation and MBIA on Moody's and Standard & Poor's credit watch lists, and the rating for Financial Guaranty Insurance Co. bumped down to double A from triple A by Standard & Poor's in early February, the market has started to separate the weaker players and price the bonds they back accordingly.

"In the old days, an 'A'-rated hospital bond insured by MBIA, Ambac or FGIC traded about 15 basis points off of pure triple-A bonds," says Geoffrey Schechter, portfolio manager of several MFS municipal bond funds. "Now, the gap is around 40 basis points."

Warren Buffett's new municipal bond insurer, Berkshire Hathaway Assurance Corp., stepped in to fill the confidence gap with the sale of its first covered issue in mid-January, a $10 million bond issued by New York City. Another beneficiary of the fallout has been bond insurer Financial Security Assurance (FSA), whose triple-A rating remains on solid footing. The firm insured bonds worth $46.2 billion last year, making it the most popular insurer. Ambac and MBIA ranked second and third with $45.5 billion and $44.3 billion of insured bonds, respectively.

"I'd look at bonds backed by Financial Security Assurance with no qualms," says Schechter. "I'd be more careful about MBIA and Ambac."
What some view as a minefield, others see as a potential buying opportunity. Fabian believes that the value of bond insurance has been long overrated, and that a credit downgrade of an insurer means little beyond market perception because municipal bond issuers rarely default anyway. "The retail investor has been sold on the value of bond insurance, even though the insured municipal credits are often financially stronger than the insurers themselves," he says. "It's a real sham."

Fabian contends that as long as the underlying credit is sound, it makes sense to look for bargains among bonds insured by firms under scrutiny. "You may not get as much total return in the short run," he says. "But if you are investing on an income and yield basis, does it really matter?"
Watch for possible credit downgrades. Given that bond insurance is no longer viewed as bulletproof, and fears of a recession are on the rise, the underlying credits and the financial strength of issuers takes on greater importance. George Strickland, co-portfolio manager of the Thornburg Municipal Bond Fund, is eyeing California bonds cautiously. "With a severe budget squeeze, there is the potential for the state's bonds to be downgraded several notches from their A+ status," he says.

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