Meredith Whitney became a household name last winter. The banking analyst, who was formerly known only by the Wall Street crowd, caught the attention of Main Street when she predicted that many state and local governments would start defaulting on their municipal bonds as 2011 wore on. Turns out, she was wrong. With the exception of Central Falls, R.I., and Harrisburg, Pa. there have been no municipal defaults, (though Jefferson County, Ala. may soon join them). Simply put, the other 99% of state and local governments have aggressively cut expenses to balance their budgets.
The iShares S&P National Municipal Bond Fund (NYSE: MUB) tells the tale, rallying to recent new highs as investors seek to broaden their exposure to this asset class. The fund, which holds at least 80% of its assets in muni bonds, is a slow-and-steady kind of investment. You can get much more upside exposure by investing in Assured Guaranty (NYSE: AGO), the nation's leading provider of municipal bond insurance.
Bond buyers take out insurance in case a loan defaults. If a loan defaults, then Assured Guaranty is on the hook for a lot of money (though it covers its bets by using re-insurers). If very few loans default, then Assured Guaranty can reap big profits. This is just what's happening right now. "Massive defaults had been predicted. But as expected and previously communicated, there's been no sign of that, not in the market as a whole, and certainly not in our insured portfolio," noted CEO Dominic Frederico in a call with analysts.
With few defaults to worry about, the business has become quite profitable. The company has earned $4.06 a share in the past four quarters. Not bad for a $13 stock. (Profits would have been $0.60 higher were it not for a recent re-classification of interest rate assumptions under certain bonds that was required by regulators.)
A steady sting of profitable quarters has also pumped up the insurer's balance sheet Tangible book value now exceeds $21 and should hit $27 by the end of next year according to UBS -- assuming no major defaults.
This is quite a caveat. After all, the biggest government borrower of all -- Uncle Sam -- recently got a slap on the wrist from bond rating from Standard & Poor's and saw its rating drop from "AAA" to "AA+". This spooked Assured Guaranty's investors, which pushed the stock from $12 to $10.30 on August 8, though it eventually became apparent the ratings downgrade would have little impact on the company's business. Now, shares are back up to $12.
In fact, the ratings downgrade could actually benefit Assured Guaranty: "if a downgrade leads to higher funding costs for municipalities, it could have a positive impact on AGO's new-business production. In a scenario in which spreads for municipal bonds widen more than AGO's, it could be beneficial for the pricing on new business, as bond insurers charge a portion of the spread," note analysts at UBS, who predict that shares will more than double to their $28 price target.
Assured Guaranty recently received a significant endorsement from super-investor Wilbur Ross, who is known for placing large (and often) successful bets on industries perceived to be in distress -- he reaped hundreds of millions in steel makers when nobody else would touch them in 2005. Ross has been buying blocks of Assured Guaranty's stock on the open market, acquiring more than $10 million worth from August 12 to August 19 at an average price of around $11.75. He sits on Assured Guaranty's board and now owns almost 17 million shares, or nearly $200 million worth. This is nearly 10% of the entire company.
Shares also found support from a Standard & Poor's announcement that Assured Guaranty -- and its rivals -- would get new creditworthiness scores this November. S&P had withdrawn its rating in 2010, citing difficulty in assessing the potential vulnerability of bond insurers. Reinstating a rating should be very helpful for Assured Guaranty because it helps endorse the health of its financial picture, which as noted earlier, is quite strong. News of the coming S&P move helped push shares up more than 10% in Thursday trading, though they still remain far below tangible book value.
Risks to consider: Is the economy slowing down and heading into recession again? If so, and states hit another wave of financial distress, you may hear of more defaults, and shares of Assured Guaranty will be hard-pressed to rise until that concern passes.
Action to Take --> With the exception of the early August swoon related to the S&P downgrade, shares sit near a 52 week low. Off of those lows, clear catalysts emerge beyond the very low price-to-earnings (P/E) and price-to-book (P/B) ratios. After successfully suing Bank of America (NYSE: BAC) for $1.1 billion for representing bond portfolios that were not as strong as the issuer (BofA) said, Assured Guaranty is now going after Credit Suisse (NYSE: CS), UBS (NYSE: UBS), JPMorgan Chase (NYSE:JPM), Deutsche Bank (NYSE: DB) and Flag Star for similar damages. Any victories would simply further strengthen the balance sheet.