Hurricanes and the Municipal Bond Market (Rebecca H. Garner Commentary)

The ripples of hurricanes Katrina and Rita consist of more than water. The ripples I am referring to come in the form of municipal entities and companies that provide insurance to municipal bond issues.

A city like Fayetteville, my hometown, is financed in part through the issuance of bonds. There are two general types of these bonds — general obligation bonds (GOs) and revenue bonds (Revs).

GOs are priced using the municipality’s good name and reputation, along with their basic tax base and taxing authority. Revs are priced using a specific revenue stream, like water and sewer bonds.

Imagine your hometown losing its entire population for a certain period of time and coming back to homes that are uninhabitable, if they come back at all. The basic tax base would be decimated, and a determination of a future tax base would be needed to evaluate the credit worthiness of a GO bond.

Likewise, when the water and sewer service is stopped, like when the plant goes down or there are no houses to service, the revenue stream counted on by bondholders no longer exists.

In these cases, any bonds, GOs or Revs, would be impaired because without revenues being paid, the interest in turn will not be paid. This is true no matter how good the reason for the non-payment.

There are three main insurers of municipal debt: Municipal Bond Insurance Association, American Municipal Bond Assurance Corp. and Financial Security Assurance Inc.

These companies guarantee bond issues as to their interest and principal payments. The issue here is whether or not these insurers are capable of making all the payments they might owe.

For example, according to their Web site, MBIA has almost $3.5 billion in public- finance exposure in counties and parishes eligible for both individual and public assistance known as of Aug. 31, two days after Hurricane Katrina hit the Gulf Coast. Clearly, the vast majority of these are located in and around New Orleans.

AMBAC says its exposure is $4.3 billion, and FSA’s is $380 million. As the hurricane cleanup continues, these numbers could change.

Now suppose you own an insured bond. The insurance results in a AAA credit rating when the bond issue, without insurance, might only warrant a single A or lower credit rating.

So if the insurance company no longer warrants a AAA rating itself, what does that do to your AAA bond? More than likely your bond gets downgraded by the rating agencies to equal the insurer’s rating or the rating of the municipality, whichever is higher, and the market value of the bond would most likely decline.

This is not to say the bond interest will not be paid or that the principal will not be paid at maturity, but it does mean that should you wish to sell the bond before the maturity date, the price you receive will probably be less than the price you would have gotten for a AAA bond.

Being the contrarian that I am, I also must say that it is possible, under this scenario, that you might also find some great bargains to buy in the municipal market, but only if you do your research on the municipality and don’t rely totally on the rating agencies. Please — know what you own!

(Rebecca H. Garner is fixed-income portfolio manager at Garrison Financial of Fayetteville. She can be reached via e-mail at [email protected].)