The primary reason to invest in municipal bonds instead of other securities is the perceived lack of risk associated with them. A reason for this lack of risk is because these bonds are secured, meaning that an investor should be confident that they will receive the interest and principal of the bond. A bond can be secured in a number of ways, but one common way is bond insurance.

How Are Municipal Bonds Secured?

Before we discuss bond insurance, investors should know that bonds can also be secured in other ways. A bond can be secured in a number of ways. For one, the party issuing the bond can ensure payment with its full faith and credit. General obligation municipal bonds are secured this way because the municipalities issuing the bonds can use their taxation powers to increase revenue to ensure payment to bondholders. An additional way the issuer ensures payment is through revenue bonds. This means that the issuer uses the revenue obtained from the projects that the bonds were used to fund to help pay back payment to bondholders. Revenue bonds are a little more risky than general obligation bonds due to the uncertainty that the funded project will make enough money to pay back debts.

Another way bonds can be secured is through third-party beneficiaries pledges. Municipal bonds will sometimes be issued for the the benefit of a private sector third party that will use the money from the bond to fund a project that will serve the public good. These private businesses then use the revenue from the public interest projects to pay back the municipalities, and in turn the municipality will pay back bondholders. Again, bonds secured this way still face risks because the revenues are not necessarily guaranteed from the projects being financed by the bonds.

What is Bond Insurance?

Bond insurance is another way bonds are secured; it is a form of third-party credit enhancement. A bond issuer will purchase bond insurance to ensure payment to bondholders in the event that they default on a payment. No matter what happens to the finances of the government or institution that issues the bond, the bond s payments on interest and principal will be made. This also helps the credit ratings of certain issuers of bonds; if the insurance company backing a bond has a higher credit rating than the issuer, then the bond issued will have the credit rating of the insurance company. This makes insured bonds more attractive to investors seeking a less volatile investment opportunity. Bond insurance also increases the liquidity of bonds because it is easier to sell a bond on the market that is guaranteed not to default.

History of Bond Insurance

Municipal bond insurance first came onto the scene in 1971 when American Municipal Bond Assurance Corporation (Ambac) was the first company to issue such insurance. The reason that this type of insurance came to the market was because these companies sought to help municipalities and other public institutions get access to better funding. Throughout the next fourteen years more and more bond insurers surfaced, including Municipal Bond Insurance Association (MBIA), Financial Guaranty Insurance Company (FGIC) and Financial Security Assurance Inc (FSA, now known as Assured Guaranty Municipal). These companies became known as the big four bond insurers.

While bond insurance seems like a wonderful idea for bond issuers, it took awhile for these triple A rated insurers to catch on; in 1980 only 3% of bonds issued were insured. However, as more and more municipal bonds faced the possibility of default, bond insurance became more popular and soon a majority of bonds issued were insured. This was evident in 1983 when the Washington Public Power Supply System defaulted on $2.25 billion in revenue bonds; most bondholders lost 60 to 90 cents on the dollar. However, the small amount of bonds issued that were backed by insurance saw full repayment from bond insurer Ambac. This was a watershed moment in the history of bond insurance and the practice became more popular. By 2007 approximately 60% of bonds were insured.

These bond insurance companies did not just focus on municipal bond insurance, however. They also insured a variety of different securities such as mortgage-backed securities and collateralized debt obligations (CDOs). Therefore, in 2007, the downfall of the housing market also affected these asset classes and the insurers that backed the payments. As more and more homeowners defaulted on mortgages, it left bond insurance companies unable to keep making payments on the securities they backed. This resulted in credit downgrades by rating agencies. In 2007 there were seven insurers rated triple A by the major credit agencies; today there are none.

This downfall on the trustworthiness in the industry resulted in hard times for the bond insurance companies. Certain bond insurers started to fold up and declare bankruptcy. In 2012, there is only major player in the municipal bond insurance market: Assured Guaranty Corporation.

What Does Municipal Bond Insurance Cover?

There are a lot of questions regarding the necessity of bond insurance for potential bond buyers. It all depends on the amount of risk an investor is willing to take on and the type of bond that might be purchased. For one, as stated above, buying a bond backed by a reliable insurer guarantees repayment of interest and principal in the face of potential default. This is a great asset for investors seeking to decrease the amount of risk in their bond portfolios.

However, since there is the lack of risk, it also diminishes the possible reward. Bonds backed by insurance usually have substantially lower interest rates. This can be fine if an investor is looking to a purchase a bond with a higher risk of default. However, if a bond that is probably not in danger of defaulting in the future is insured, it brings down the interest rate unnecessarily. This makes the bond insurance counterproductive for potential investors.

There are also questions about whether bond insurance companies would be able to withstand the possibility of widespread defaults and government bankruptcies. States and municipalities across the country have been racking up debt and there have been some instances of bankruptcies. It is unknown whether, in the face of widespread defaults, if Assured Guaranty Corp would be able to ensure payment on its insured bonds. The company says it has $13 billion readily available to assure repayments. However, the company insures over $400 billion in bonds and other securities. It is impossible for the company to cover all payments in the event of widespread financial crisis. The bond insurers face risks just like any other bond, security or asset; investors need to be aware that even in the face of limited risk, there is still risk that can bring losses to a portfolio.

Who Provides Municipal Bond Insurance?

For the longest time, the big four bond insurers included Ambac, MBIA, FGIC and FSA. There were other smaller triple A rated insurance companies, but these were the big players that insured a majority of the municipal bonds. For the most part, these big insurers would eventually acquire the smaller insurers. However, after the financial crisis in 2007 these big insurers started to see downgrades of their credit ratings. This eventually lead to bankruptcies and tough financial times. It was common that the bond insurers would either fold or see insignificant credit ratings that lead to little business. The only company to break through to the other side was Assured Guaranty Corp, which acquired FSA (which is now known as Assured Guaranty Municipal Corp.) These insurers have the highest credit ratings and thus insurer most of the municipal bonds and securities today. It should be noted that in July of 2012 a new bond insurance company was licensed, Build America Mutual Assurance Company (BAM), which intends to only insure securities with a public purpose.