Municipal bonds — those low yielding, tax-exempt stars of a bear market — are not the risk-free investments that people often assume.

Consider the $200 million in municipal development authority bonds backed by Kmart rental payments that have fallen into default because of the retail chain's bankruptcy. Or the United Airlines-backed bonds floated to expand facilities at O'Hare International Airport, which tanked after September 11. As a growing number of municipal bonds backed by specific revenue streams become distressed, some muni bond experts have begun to caution investors to stick to bonds backed by general municipal revenues.

Bob Smith, president and CIO of Sage Advisory in Austin, Texas, cautions that even general obligation bonds are not as straightforward as they used to be. Investors, he says, are overconfident in the companies that offer municipal bond guarantees. Over half of all municipal bonds are now backed by financial guarantees that confer AAA ratings, even when the cities, states or agencies that issue them are rated below AAA.

“What many people don't realize is that they are private companies, not government agencies that are mandated to work in the public interest,” Smith says.

If the guarantors become unstable, the prices of the bonds they guarantee could collapse. Such an event would catch retail investors and many brokers alike by surprise. There are four companies that dominate the financial guarantee market. They are MBIA (NYSE: MBI), Ambac Financial Group (NYSE: ABK), Finance Security Assurance (NYSE: FSA) and Financial Guaranty Insurance (a unit of GE Capital). A bond issuer can buy a guarantee, also called a wrap, from any of these companies to raise their bond rating and reduce their borrowing costs. In return for an annual fee during the life of the bond, the financial guarantor, or wrapper, pledges to pay investors all regularly scheduled principal and interest payments if the issuer cannot meet its obligations.

The wrappers' stocks had a bumpy year in 2001. First, they were hit by the California utility crisis. MBIA, the largest of the financial guarantors measured by its insured portfolio, has a combined exposure of $1 billion to Southern California Edison Company and Pacific Gas & Electric. That's about 10 percent of the company's $10.1 billion in claim-paying resources. Then came September 11. MBIA's exposure to New York City is about $8 billion, and the company has an additional $15 billion in exposure to U.S. airports and airlines — totaling more than two times its reserves. Ambac puts its exposure to U.S. airports at $6.5 billion.

“Totaling those numbers doesn't make any sense,” says Dick Weil, MBIA vice chairman. “The way to look at our risk is to look at probability. Will people really stop using airports?” He notes that the company's losses have historically been three basis points, or 0.03 percent, of its guaranteed portfolio. He adds that MBIA's legal rights to payment exceed that of other creditors. And even when MBIA must make claim payments, it is often reimbursed. This was the case after MBIA paid investor claims of $660,000 when Southern California Edison failed to make coupon payments on two of its insured bonds in January 2001. MBIA anticipates no losses because of either crisis.

Nonetheless, the terrorist attacks did trigger downgrades of several bonds within the insurers' portfolios. Additional downgrades are likely, though none have yet to be put on the watch list, says Jack Dorer, a senior vice president at Moody's. However, he adds: “Further deterioration in the airport bond sector, for example, could increase the risk profile of the guarantors' portfolios.”

Smith argues that other trouble spots could emerge within their portfolios. Financial guarantors don't just specialize in municipal bonds anymore. They have diversified, now offering guarantees for more complicated structured corporate finance instruments and international debt. Smith says the risk of default of bonds in these new businesses is likely to be higher than in municipal bonds, where the default rate has been less than 0.5 percent over the past 40 years.

It wouldn't even take the bankruptcy of one of the financial guarantors to wreak havoc in the muni bond market. A simple downgrade to one notch below AAA would serve as a wake-up call for investors who currently assume that there is no risk in holding guaranteed municipal bonds. Such a sudden change in perception would possibly trigger a steep decline in bond prices.

Some advisors suggest that investors should apply the diversification rule to their muni bond portfolios — just as they should not load up on bonds from any one issuer, their bonds should hold guarantees from a variety of wrappers.

Patrick Early, manager of municipal bond research at A.G. Edwards, says that if one financial guarantor finds itself in trouble, investors will suddenly question all guarantors, and all wrapped bond prices will fall. “A downgrade would be a big psychological blow to the market,” he says. “The reason so many bonds trade so freely is because the insurers have homogenized the market.” But a threat of a downgrade? “I think that's a stretch.”

Even Smith believes that muni bonds are still sound investments for retail clients. It's just the prices paid by many retail investors may be inappropriate.

All investments carry some risk — the role of the market is to assign a price to that risk. Large institutional investors have long demanded a small discount for guaranteed municipal bonds relative to AAA municipals that do not require insurance to earn the top rating. The discount reflects the notion that any risk, no matter how small, should be reflected in a bond's price. The yield differentials between uninsured AAA bonds and those that required insurance to obtain an AAA rating are illustrated in the chart.

Smith charges that retail investors are not always offered the same discount.

The first obligation of financial planners is to make sure that their clients understand the risks involved in the bonds they buy. And their second obligation is to make sure their clients are compensated for these risks, however small.