Bond insurers have been in the news lately as their forays in the subprime quagmire have come to light. Naturally, this has caught the attention of muni buyers, who wonder whether the insurers are strong enough to withstand substantial claims. This scrutiny has also given rise to other provocative questions, one of which was raised recently by an astute client: Is bond insurance even necessary on issues with strong underlying ratings?
We thought it was a timely question, meriting discussion here.
Who wins with insurance?
Since its inception, bond insurance has been viewed as one of the few financial innovations that benefits everyone. Issuers gain from the quality enhancement by borrowing at a lower interest cost. Investors enjoy the peace of mind provided by the additional layer of security. But most important to this discussion, insurers profit by receiving substantial premiums for providing coverage to bond issues that in most cases don’t need it. Investment-grade issuers provide excellent security in their own right.
The growth of bond insurance has also created other winners: Financial supermarkets and internet aggregators, who tend to paint all insured bonds with the same brush. It allows them to recommend bonds without doing any homework.
Investors should be reassured
Although investors may regret paying more to have their bonds insured, the recent woes experienced by insurance companies aren’t likely to affect the timely payment of principal and interest.
AAA insurers have always taken an extremely conservative approach to the municipal bond market by employing stringent criteria before providing coverage.
Bond insurers are only compelled to pay principal and interest if the underlying borrower cannot do so. Remember, issuers in the municipal market almost invariably meet their payment obligations. (See “Study Shows Muni Debt Stronger, Defaults Negligible.”)
MBIA, for example, requires issuers to have an investment-grade credit rating (BBB or better) to qualify for insurance. The fact is, municipal bonds just don’t default very often. Those that do are generally smaller, unrated issues that wouldn’t qualify for bond insurance in the first place. According to MBIA, in its 30-year history, it insured 93,211 issues and incurred losses on only 102 transactions.
It is unfortunate that some of the bond insurers abandoned their cautious approach when venturing into what they perceived to be more lucrative markets.
But holders of AAA insured bonds need not be alarmed by the startling announcements from the insurers who have become ensnared in the subprime mess. Investors can rest assured that their bonds, not an insurance company, are providing their steady stream of tax-free income.
Judge issuers on their own merit
Bond insurance alone doesn’t tell the whole story. As municipal bond specialists, we thoroughly research the securities we offer to investors. Our approach to this research necessarily involves scrutinizing uninsured bonds as well as the underlying credits of insured bonds. That’s the job of our municipal credit analyst, Jay Abrams, Ph.D., who publishes numerous credit reports posted on our “Analysts’ Insight” page.
Thankfully, more bond investors are beginning to recognize there is considerable value in examining the security of uninsured issuers on their own merit when determining the value of their investment.