Municipal bonds are still safe, even if insurance isn't

A: The credit crunch started by affecting subprime mortgages. But it soon became clear how interwoven credit markets are as problems spread to other parts of the bond market.

Even municipal bonds, which are considered some of the safest fixed-income instruments, have been affected. But don't worry, munis haven't been affected the way you might expect. They are still considered safe places to park money. If anything, they are suffering from a side-effect of the subprime debacle.

Here's what's going on: At the root of the problem are bond insurance companies, such as Ambac and MBIA. These companies are in the business of guaranteeing bond payments to make investors feel better about buying the bonds. Normally these firms insure stable bonds and have plenty of cash on hand to handle losses.

A good portion of the bond insurers' business comes from guaranteeing bond payments by cities, states and local governments that borrow money using municipal bonds. Municipal bonds have been extremely safe over time, and they don't really need insurance. But sellers of munis offer insurance to attract investors from outside the issuer's immediate region.

For example, let's say the city of Los Angeles wants to borrow money to fix a bridge. If the city sold bonds without insurance, investors would need to go look at the bridge, talk to the city, find out about the project and go to great effort before investing. That might be a turnoff for investors living in New York. But, if the bonds are insured, investors can buy them without the same level of due diligence.

But, here's the problem. Because of the problems with securities whose payments include proceeds from subprime loans, there are questions about how financially solid the bond insurers are. They are on the hook to cover losses from subprime loans. The worry is if the subprime losses balloon, the bond insurers could fail.

The result? Yields on some insured muni bonds have risen and prices have fallen as investors figure the bond insurance could be worthless. Does this mean the muni issuers are more likely to default? No. It just means investors are demanding lower prices and higher yields for the bonds to compensate for the increased risk. They see insurance as having limited value now. You can read more about this here.

But the bottom line is clear. Muni bonds have been and continue to be safe investments. Defaults are rare, and even in cases of default, investors typically get their money back. If there's any change, it's that if you're buying munis based on the fact they're insured, you might want to take that insurance with a pinch of salt.

Matt Krantz is a financial markets reporter at USA TODAY and author of Investing Online for Dummies. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt at mkrantz@usatoday.com. Click here to see previous Ask Matt columns.