Although many investors may be familiar with the concept of municipal bond insurance, they may not be as familiar with what it means in the context of secondary market trading. They may also not be aware of the mechanics behind how a bond gets insured and the possible ramifications of that insurance. While thinking about the natural progression of the article series hosted here on MunicipalBonds.com, I felt the right next step would be to discuss these and other intricacies of bond insurance in the secondary market.
The Reality Behind Bond Insurance
As discussed in previous articles, municipal bond insurance can provide an additional layer of protection to the investor in the event an issuer faces a credit or payment issue. The three active insurers of municipal bonds are Assured Guaranty, Build America Mutual and National Public Finance Guaranty, and each brings a credit rating of AA- or better. The strong credit ratings of the bond insurance companies can be essential in the secondary market, since many traditional municipal bond investors tend to be buyers of credits above an A rating.
A strong example of the power of insurance is Puerto Rico. Insurers guaranteed certain of the island’s credits well before the crisis hit. Investors need to look no further than bonds backed by the Puerto Rico Highway and Transportation Authority Revenues. According to Bloomberg, certain cusips of this issuer were insured by names like Assured Guaranty and currently trade around a $100 dollar price, while uninsured bonds of the same issuer trade in the $20s!
How To Obtain Bond Insurance
So, how does a bond get insured? There are two main ways: the primary market or the secondary one. In the case of the primary market, the municipality or issuer of the bonds engages the insurance company to analyze the credit. If the insurance company agrees to underwrite or “wrap” the credit, depending on the nature of the issuance, either the bond underwriter or the issuing entity pays a premium to the insurance company. Many municipalities and issuers are happy to pay this fee, as the additional layer of safety provided to investors often results in lower overall funding costs to the issuer. The long-term savings to the municipality and increased breadth of the investor base eligible to buy the securities make the prospect of bond insurance appealing wherever possible.
The second avenue to a bond getting insured is secondary market insurance. In this case, a client in the marketplace, often a broker-dealer, will identify the credits that are lacking in the insurance and that may fit within one of the major bond insurers’ criteria. The bond insurer will then qualify the credit, based on a variety of internal requirements related to its view of the obligor’s financial condition and fiscal management, regional economic factors, political factors, how much exposure the insurer already has to the credit or related credits and how the credit affects the sector and geographic diversification of the insurer’s portfolio of insurance exposures. Additionally, each insurer may have its own restrictions against insuring in certain bond sectors, jurisdictions or transaction sizes (e.g. no hospitals, not more than a fixed percentage of statutory capital, etc.).
Once a credit is identified, qualified and approved, a bond insurer will set a premium to collect in exchange for providing the insurance. In exchange for the premium, the insurer provides assurance they will make timely coupon and principal payments according to the existing structure of the bond in the event of a credit situation. The cost of this premium will be based on a number of factors including any rating agency capital charge an insurer may need to absorb relating to the bond sector, maturity of the bond or quality of the underlying credit. Additionally, the premium may reflect costs associated with rating the new credit and creating a new cusip, as the newly insured bond will have a unique identifier to distinguish it from other non-insured bonds of the same structure.
How Can Investors Benefit From Secondary Market Insurance?
Situations where bonds are insured in the secondary market can be beneficial to many parties in the marketplace. The insurance company gains an opportunity to guarantee a credit or bond issue it may not have had access to in the primary market, while the broker-dealer and retail client may be in a position to purchase and insure a bond for a lower all-in cost than comparable insured bonds are trading in the marketplace or to create a bond that meets both the rating and structure requirements of a particular investor. Institutions may be able to reclassify the rating of a bond for portfolio management purposes.
Secondary market bond insurance allows those in the market to purchase a layer of protection against potential future pricing pressure on certain investment grade credits. Investors have recently used this technique to insure credits in the market, including but not limited to: Cook County Illinois, LaGuardia Airport, Chicago Wastewater, NY City University, Charleston Airport and Oklahoma Municipal Power Authority. In the case of two of the aforementioned situations, Cook County and Chicago Wastewater, insured bonds of these issuers have held up better in the secondary market as the credits have come under some pressure. This is due to a larger and more diversified buyer base, as well as the added layer of safety afforded by the insurance wrapper. Regardless of the mechanism used to insure a municipal bond, it is clear from both the market pricing and the reduced volatility of insured bonds that the layer of safety provided by bond insurance is valued in the marketplace, and is an essential tool for investors to employ.
About the Authors
This article was written by Ben Seelaus and Robert Bertoni.
Ben Seelaus is COO at R.Seelaus & Co. He joined the firm as a Managing Director in October of 2014. Ben spent the first 10 years of his career as a market maker and trader of U.S. Government Bonds for several firms including JP Morgan and HSBC. Just prior to joining Seelaus, Ben was a Managing Director and Head of U.S. Government Bond trading for Morgan Stanley.
Robert Bertoni has been in the R. Seelaus & Co. muni trading department for two years. He began his career with HSBC in their middle office group. He currently holds his Series 7, Series 63 and is a Level 3 CFA candidate.
Learn more about Ben and Robert here.
Sponsored by Assured Guaranty Municipal Corp., Municipal Assurance Corp. and Assured Guaranty Corp., New York, NY. This article is for informational purposes only and does not constitute (a) an offer to sell or a solicitation of an offer to buy any security, insurance product or other product or service, (b) financial, tax, legal, investment or accounting advice, or © advice with respect to any municipal financial products, or the issuance of any municipal securities, including with respect to the structuring, timing or terms of any such financial products or issuances. None of the sponsors or any of their affiliates is acting as an advisor in connection with any municipal financial product or any offering of municipal securities.