These Mutual Funds May Keep Rallying

Vanguard Insured Long-Term Tax-Exempt(VILPX Quote), a fund with $3.2 billion in assets, was merged out of existence. "We concluded that a fund focused solely on insured bonds no longer provides tangible benefits," says Gus Sauter, Vanguard's chief investment officer, in a statement.

Insurance has long been a mainstay of municipal markets. As recently as two years ago, half of all new issues were insured. Although few new issues are now insured, funds still hold plenty old bonds that are backed by insurance. Should you worry if your fund holds insured bonds? Not necessarily.

Prices of insured bonds have already collapsed to bargain levels. Portfolio managers say insured bonds aren't likely to fall much further. To appreciate why, consider how insurance works. Say that Standard & Poor's gave a hospital an A rating, a strong investment-grade mark. When it issued bonds two years ago, the hospital purchased insurance coverage. According to the insurance policy, the hospital would make regular interest payments on its bonds. The insurance would only come into play if the hospital defaulted. Because of the extra layer of protection, the hospital bond could be rated AAA. That improved rating pushed up the bond's price and made it easier to sell.

Then, in 2007 and 2008, bond insurers faced losses from mortgage-backed securities. With investors worried about defaults, prices of insured bonds dropped. The insured hospital bond fell back to trade according to its old A grade. In effect, the insurance had become worthless and had no impact on the value of the bond.

Now even if the insurers default, the bond market shouldn't be troubled. With the value of insurance already at zero, it cannot fall further.