Municipal Bond Insurance: The Basics
If you are considering buying municipal bonds, you mayl need to decide whether to buy bonds with insurance policies designed to protect your investment.
What is municipal bond insurance?
It is simply a guaranty that the holder of a municipal bond will receive scheduled interest and principal payments when due, even if the municipal issuer fails to make these payments. It is literally an insurance policy against an issuer’s payment default.
Does it matter which company provides the bond insurance?
Well yes and no. Almost all municipal bond insurance companies are on the brink of collapse except Assured Guaranty. But no matter which insured bonds you own, you may not not get the long term benefit of insurance payments if there were to be say 20 large defaults or bankruptcies. That said, there are other benefits to having a strongly rated insurance company backing bonds such as loan collateral requirements that give the insurance company strong leverage powers during a default proceeding. This is the case with Assured Guaranty (AGC) and the now defaulted Harrisburg PA. incinerator project bonds. AGC has the hypothetical right to require the municipalities that backed the bond (Harrisburg, Dauphin County, etc) to sell other assets such as parking garages or to even force a tax increase.
Do I still need municipal bond insurance?
While municipal bond defaults have been rare, they occur more frequently in periods of economic stress. In 2009 there were about 250 defaults accounting for several billion in assets. That doesnt mean these bonds are dead, just that they need to work out a new payment plan. Most probably will. But few individual investors hold enough different municipal bonds to make this risk inconsequential, especially because they typically concentrate on bonds in their home state to gain the maximum benefit from the tax-exempt status of many municipal bonds. The decision to buy insured bonds will depend on your circumstances and risk tolerance. Here are some questions to ask yourself and related reasons that you might prefer bonds with insurance:
“How well do I know the municipality’s fiscal condition and the structure of the bond?” Insured bonds have been pre-selected for soundness by the guarantor. Guarantors back up their opinions with an obligation to pay interest and principal from their own capital if the issuer fails to do so. Additionally, by choosing insured municipal bonds, you gain the benefit of a professional surveillance staff whose only job is to keep tabs on the issuers of the insured bonds. In many cases, these professionals spot trouble ahead of time and can call upon, or even require, the municipality to take remedial steps before a default looms.
Who provides municipal bond insurance?
Only financial guaranty insurance companies may write bond insurance. You may hear these companies called “bond insurers,” “financial guarantors,” “monoline insurance companies” or just “monolines.” All these terms refer to the same group of companies, which operate solely as guarantors of financial obligations and are subject to specialized regulation.
“Would I be able to tolerate a drop in market value, or even the potential inability to sell my bonds, if a municipal issuer’s financial condition deteriorated?” Although bond insurance does not guarantee a particular market value, distressed issuers’ bonds insured by highly rated guarantors have historically held their trading value better than comparable uninsured issues.
“If a municipality missed one or more interest or principal payments, could I afford to be without the cash flow for a number of years until I could obtain a recovery?” If a municipality cannot make a scheduled payment on an insured bond when it is due, the bond insurer is obligated to make prompt payment in full.
How are bond insurers regulated?
As insurance companies, financial guarantors must be licensed to write insurance by the state insurance department in each state where they insure bonds and must meet their obligations to policyholders before other creditors. Additionally, financial guaranty insurers must restrict their business to financial guaranty and related types of insurance (hence the name “monolines”). Under financial guaranty statutes, financial guarantors must comply with capital, liquidity and reserving requirements as well as limits on their financial guaranty exposures.
How do I get bond insurance?
You generally do not buy the insurance directly. Instead, you buy bonds that were issued with insurance. (Issuers arrange to have their bonds insured in order to attract more investors and improve the efficiency of their bond offerings.)
A new twist is that dealers may purchase insurance for bonds already trading in the secondary market, typically for larger positions.