These securities are experiencing a bubble after a rally in May and a sell off in June, said Matt Fabian, a senior analyst and managing director of Municipal Market Advisors of Concord, Mass.
Through the second quarter, the general muni debt funds had a gain of 0.67%. Insured muni debt funds earned a quarterly return of 0.86%.
Adding to the challenge, bond insurers MBIA Inc. of Armonk, N.Y., and Ambac Assurance Corp. of New York in June had their insurance financial-strength ratings slashed to A2 and Aa3, respectively, by New York-based Moody's Investors Service.
Exposure to mortgage-related securities within the companies' insured portfolios was among the factors behind the loss of their sterling Aaa ratings.
The securities that are guaranteed by MBIA and Ambac have also been downgraded, except for those with higher public ratings, according to Moody's. In response, demand for these bonds has slowed down, while high rated bonds are sought after, muni experts reported.
'RICH YIELD'
"We are in a rich yield curve. In two weeks, we have gone from a poor market to a bubble," Mr.Fabian said. "We are in a boom and bust cycle, and the market is extremely illiquid."
The situation at the end of June was similar to that of January and February, when monoline insurers faced their first round of downgrades due to their coverage of structured debt linked to subprime mortgages.
Back then, the problem — along with the fear of a bond fire sale following downgrades — was bad enough that Eric R. Dinallo, New York's insurance superintendent, interceded with a plan to strengthen the carriers.
Yet the conflict with the bonds themselves isn't nearly as dire as was thought in February, industry observers said.
Some dealers and investors are re-wrapping high-quality bonds with stronger insurers, such as Berkshire Hathaway Assurance Corp. of Omaha, Neb., in order to enhance liquidity, said Tim Ryan, vice president and unit head of the muni bond group at State Street Global Advisors in Boston.
"In this go-around, there's a lot less leverage in the market than there was in February, and there's less complacency," he said.
Financial advisers who work with muni bonds have told clients to think long-term and hold the securities to maturity.
"My clients are conservative, so when we buy a five-year Portland [Ore.] sewer system bond, they know their statement shows a plus or minus on market value," said Robert J. Rockwell, a certified financial planner at Clackamas County Bank in Sandy, Ore. "But we're holding it until it matures, so we ignore the market fluctuations because they're irrelevant unless the clients sell."
Mr. Rockwell has also expressed distrust in the ratings agencies and the bond insurers, going by his own muni bond research and turning to even safer alternatives, such as certificates of deposit insured by the Federal Deposit Insurance Corp. in Washington.
Institutions that run bond funds are also remaining in the game, watching the underlying credit and market values of the securities.
"We owned MBIA, Ambac and [Financial Security Assurance Inc. of New York] in varying amounts; we weren't required to liquidate them," said Tom Spalding, vice president and senior investment officer of Nuveen Investments Inc. of Chicago.
The company had changed its permitted investments this year, so it didn't need to sell insured paper in the funds.
"There's no prospective reason to sell them just because of the downgrade, as long as we felt the bonds continued to meet the investment objective of the portfolio," said Mr. Spalding, who is also portfolio manager of the Nuveen Municipal Value Fund Inc.
BUYING OPPORTUNITY
Short-term-bond funds face problems with valuation and a dearth of liquidity, Mr. Fabian said.
As a result, downgraded bonds from these funds were sent back to the market, affecting prices for the short term, Mr. Ryan said.
Money funds, which "were caught off guard," owned more MBIA- and Ambac-wrapped securities than expected, and many had put the bonds back on the market after the downgrades, Mr. Fabian said.
Although advisers and portfolio managers are in a holding pattern, Mr. Fabian said a buying opportunity could be present for aggressive investors who want to purchase insured, formerly rated bonds, which are cheap, but fairly illiquid and face uncertain valuation over the next six months.
"You can get exceptionally good tax-exempt[-bond] deals," he said. "You have to find a rare breed of aggressive retail investor."
E-mail Darla Mercado at dmercado@investmentnews.com.
