The municipal bond market is a very large, complicated place but there are ways to sort it out. One way to simplify the market is to be aware that some bonds have municipal bond insurance attached to them while others do not. For bonds that do have insurance, how should investors look at them? What are the factors that investors should examine when considering insured municipal bonds?
The Bond Issuer’s Credit Quality
One place to start is the credit quality of the entity that issued the bonds. Investors should always remember that the bond issuer is the first source of security for insured municipal bonds. An understanding of what kind of pledge secures a bond is a critical starting point for knowing what you own in the municipal bond market. Investors should also get a sense, through their own analysis or in consultation with muni bond professionals, of the relative strength of a bond’s credit quality. Is the bond in question strong or weak in its rating category? What are the chances of a rating downgrade? Examining these questions can help investors assess a central issue when considering insured municipal bonds: What’s the likelihood of the second source of security – municipal bond insurance – being called into service? As the probability rises that municipal bond insurance might be called upon, its value to investors increases.
The Two Parts of Credit Risk
Determining credit risk has two general points of inquiry: What is the risk of an actual default in principal or interest payments, and what is the risk of credit quality deterioration? Investors should examine both risks and keep in mind the role that municipal bond insurance can play in mitigating those risks. To use a simple analogy, you could say that actual non-payment is something like an issuer falling off a cliff. For munis, this is usually not an all-or- nothing kind of cliff, since recovery rates in the muni world tend to be higher than for corporate bonds. Using the same cliff analogy, an assessment of credit deterioration risk examines the probability of an issuer in the future getting closer to the edge of the cliff from where it currently stands.
Municipal bond insurance can help to mitigate both components of credit risk. Insurance can help bondholders who own bonds that have “fallen off a cliff” by stepping into the shoes of the issuer and paying any missed principal and interest payments to bondholders, as they come due. Bond insurance can also help when credit deterioration (or even the perception of it) comes into play. Knowing that the insurance from a strong muni bond insurance company will kick in for the investor tends to make troubled credits with insurance hold their value better than uninsured bonds from the same issuer.
Bond insurers have the incentive to choose the transactions they insure carefully – because they are responsible for 100% of principal and interest due if the issuer does not pay and they are committed for the life of each insured bond. For investors who do not have the time to probe the financial disclosures of municipal obligors in depth or lack the requisite knowledge of municipal accounting and differing security provisions, insurance leverages both the bond insurer’s experience and the resources it devotes to insuring well-selected investment-grade municipal credits.
Bond Maturities and Liquidity Factors
Assessments of credit quality can be coupled with other factors to consider: the maturity of the bond in question and the liquidity needs of the investor. No investor or analyst has a perfect crystal ball and the longer time frame associated with longer maturity bonds will naturally reduce the confidence level of any credit quality assessment. Investors must decide for themselves the point at which any crystal ball assessment of future creditworthiness becomes too cloudy to go it alone. Is it five years? Seven years? Ten years? Wherever that point might be, investors can seek the additional security of municipal bond insurance on bonds with those kinds of maturities and beyond. For investors who have particular short-term liquidity needs, the additional security of municipal bond insurance should be valued regardless of credit and maturity factors. The recognizable name of a strong insurance company on a bond should improve relative trading flexibility and liquidity.
The Financial Strength of the Insurer
In addition to issuer credit quality, bond maturity and investor liquidity needs, the financial strength of the municipal bond insurance company itself should be considered. Investors looking at insured municipal bonds need to know the strength and reliability of that second source of security – should it be necessary to use it. Getting an idea of the claims-paying resources of a municipal bond insurance company is one indicator of financial strength. Understanding an insurance company’s capital adequacy in various hypothetical economic stress scenarios is another way to assess financial strength. A quality, well-diversified existing book of business and the ability to write meaningful new business are factors that can enhance the financial strength of municipal bond insurance companies as well. While it is challenging for retail muni investors and even muni bond professionals to become in-depth, expert insurance company analysts, a sense of insurance company financial strength can be gleaned from information available on company websites and in rating agency reports.
Viewing Municipal Bond Insurance on a Spectrum
For investors, one way to view the usefulness of municipal bond insurance is on a spectrum. Investors with high liquidity needs will find the existence of insurance on a bond quite necessary and helpful in improving trading flexibility. Investors who dwell in already-challenged and troubled credits or in longer maturities will also place greater weight on municipal bond insurance. Investors who have concerns about the prospects of credit deterioration on the bonds they hold will appreciate the down-the- road assistance insurance can provide. Even when investors don’t find themselves in the situations just described, the existence of municipal bond insurance can be simply a handy thing to have – a ready when you need it additional source of security in an uncertain, sometimes volatile investment world.
About the Authors
This article was written by Bernard Garruppo and Tom Dalpiaz.
Bernard is a Partner and Managing Director of R. Seelaus & Co., Inc., the corporate parent of Granite Springs Asset Management, LLC, where he previously served as Chief Executive Officer. He has almost 30 years of experience in municipal and other fixed income markets.
Tom is Managing Director, Municipal Bond Investments, Granite Springs Asset Management LLC. Tom Dalpiaz has over 30 years of experience in the municipal bond trading and investment business.
Learn more about Bernard and Tom 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.