BONDS AND INSURANCE RARELY

make for exciting cocktail chatter. But put them together and you've got one of the hottest topics du jour: The fate of bond insurers as they face a wave of rating downgrades and why almost everyone will feel the pain of those downgrades, even if they've never owned a bond in their life.

Bond insurers guarantee the timely repayment of a bond's principal and interest if the issuer defaults. Historically, most of their business has been to insure municipal bonds, which are generally safe, low-default securities issued by states, cities and municipalities in order to finance various projects, such as building a highway or school.

However, the past subprime mortgage boom seemed too attractive to pass up and some of the country's largest bond insurers started backing mortgage securities. That shift, of course, has left many insurers in hot water. Ratings agencies like Standard & Poor's, Moody's and Fitch Ratings have grown concerned about these insurers' financial strength and even the threat of insolvency if they're forced to cover the rising wave of defaults in the months ahead, prompting them to downgrade some insurers and put others on "ratings watch negative," a sign that they could very well follow suit.

In mid-January, Fitch Ratings and Standard & Poor's lowered the triple-A rating of Financial Guaranty Insurance Co., or FGIC, and Ambac Financial, two of the country's largest insurers, to double-A. Last week, Moody's issued its first downgrade as well, slashing the rating of Security Capital Assurance to A3, from triple-A. Fitch Ratings, meanwhile, has announced a change in the modeling assumptions it uses in rating bond insurers, to reflect the expectations of a sharp increase in losses because of subprime exposure. It has also placed insurers MBIA and CIFG Holding on "ratings watch negative," a sign that a downgrade is very likely.

These downgrades have far-reaching ramifications. In the bond insurance business, a triple-A rating means everything. When a bond issuer, say a state-run hospital in West Virginia looking to finance the construction of a new wing, purchases insurance, its bonds automatically receive the rating of the bond insurance company. So if that issuer isn't able to get triple-A rating on its own, a bond insurer's triple-A rating will allow it to borrow at cheaper rates, explains Scott Berry, senior mutual fund analyst with investment research firm Morningstar. (Municipal bond rates are typically lower than those of taxable bonds, but their net returns are higher once tax exemptions are factored in.)

That's bad news for those who own municipal bonds, since a bond's value automatically decreases when it gets downgraded. At the same time, its perceived level of risk increases, and in the world of investing, higher risk usually equates to higher returns. However, while investing in municipal bond funds may seem like an attractive proposition for individuals seeking high yields, some large institutional investors, like money-market-fund managers, are not celebrating.

That's because money-market funds are prohibited by the Securities and Exchange Commission from holding securities rated below double-A, which means that potential downgrades of the insured municipal bonds would make these off-limits to money-fund managers. "The likelihood is very thin that there will be any credit or liquidity issues [because of the insurer downgrades], but it certainly is a headache for fund managers," says Peter Crane, president of Crane Data, a research firm specializing in money funds and other short-term investments.

Currently, more than $470 billion of money-market fund assets is invested in municipal bonds, with roughly half of that exposed to insurers, according to Crane. That's roughly 10% of the total outstanding municipal debt, which is now $2.6 trillion, according to Municipal Market Advisors.

Money-market-fund investors are unlikely to get hurt the funds aren't in danger of "breaking the buck," according to Crane but the same cannot be said for the bond issuers themselves. "The states and municipalities are going to bear the brunt of this problem," Crane says.

With mutual funds out of the picture as potential buyers, those municipalities that aren't able to secure triple-A or double-A ratings on their own may find it difficult to sell their bonds, which means they may have to forego financing new projects, says Jeff Tjornehoj, senior research analyst at investment research firm Lipper. At best, they may have to get used to borrowing at higher rates. At worst, they may opt to raise taxes in order to fill that gap. "[Consumers] are going to feel [the downgrades] in ways you haven't anticipated," he says.

Then again, many bond issuers may find that they can do just as well, if not better, without insurance. While the bond insurers are scrambling to raise millions of dollars to cover potential losses in the mortgage market, many municipalities remain as likely as they were before to make good on their debts. "If a municipality could by itself get an A or double-A rating, the question is whether it would even want to pay for the insurance if they're not going to get a triple-A rating," Berry explains. "They could lose a lot of business."

In the meantime, insurers are being extended some possible relief: Tuesday, Warren Buffett's Berkshire Hathawayoffered to assume $800 billion in municipal bonds that are covered by Ambac, MBIA and FGIC. If more offers like this one or the proposed bailout of FGIC by a consortium of eight banks now reportedly in the works are successful, then perhaps both Wall Street and Main Street can be spared some of the collateral damage.