In a well diversified portfolio, municipal debt plays a key role in adding to its stability and creating a steady stream of payments.
It’s also true that, when compared to all other asset classes, municipal bonds are a relatively safe investment option. Municipal debt is typically backed by some form of tax revenues. Given the size and complexity of the transaction, credit rating agencies often vette and analyze the issuance prior to the issuance, which determines the level of known risks reflected by its credit rating assessment for any particular debt issuance. Although municipal defaults are rare, municipal debt investments aren’t completely risk-free ventures and there is a level of risk associated; these risks are often related to natural disasters, recessions/economic downturns, and issues like pension obligations.
In this article, we will take a closer look at how bond insurance can help enhance the prospects of municipal debt for both issuers and investors.
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Assessing the Risk Related to Municipal Debt
When reviewing the levels of risk associated with any municipal debt, credit rating agencies often take a comprehensive look at the financial health of the municipality, type of debt, and revenue streams. In general obligation debt (GO), this includes things like:
- A detailed understanding of the socio-economic and demographic make of the municipality and level of suitable taxation
- A comprehensive look at the type and level of services offered to the residents through the current level of tax revenues
These two components are then divided into subsections in the risk assessment:
- The sustainability of the local/regional tax base and an economic outlook: When reviewing the strength of the local and state economies, this is one of the most important areas that entails a list of the largest employers in the area, diversity in employment areas, education, and workforce participation. All these things lead to a comprehensive review of the area and how a financial downturn will impact the tax base in the local economy.
- Fiscal preparedness of the local economy: As aforementioned, the local and state economies run their operations from a wide array of revenue sources generated through different taxation and services performed. In an economic downturn, you might see one of the multiple revenue streams impacted, leading to budget imbalances and financial strain on overall operations. The financial collapse of 2008 was a prime example that hit both the property and sales tax revenues for local and state governments, which are often the two largest revenue sources. Since then, more and more local and state governments have implemented financial preparedness plans to combat the unforeseen impacts to their current revenue levels. These include things like establishing financial reserves for a rainy day and planning for future expenditures, like pensions.
- Current debt obligations: It’s also critical to review the overall debt portfolio of any local government to understand its current outstanding debt, its underlying pledge, and how it will impact future issuances. In addition, in the event of an unforeseen event, it details how the existing debt will be paid back.
The aforementioned risk assessments are also applicable for municipal debt backed by certain revenue streams, also known as revenue bonds. However, you’d often see the risk assessment focusing on the project being funded and how the revenue streams, pledged for this debt, can/will be impacted in an economic downturn.
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Understanding the Benefits of Bond Insurance
Bond insurance is typically taken by the issuer of municipal debt during the debt issuance for many reasons. Some of these reasons include:
- Credit rating agencies view an insured debt transaction more favorably with less risk to the investors; in turn, the transaction will likely have a higher credit rating compared to the same transaction with no insurance
- For the issuer, a debt issuance with a higher credit rating will garner more interest from investors and can be more cost effective due to another level of security provided by the bond insurer
- In the event of a rating downgrade of a municipal debt, investors might find that an insured debt instrument will still have market liquidity to sell the issuance compared to an uninsured debt instrument
Now, let’s take a look at how bond insurance will protect investors:
- Natural disasters: In the event of a natural disaster, municipalities can face significant issues related to their fiscal sustainability and disrupt cash flows. In the event a municipality faces inadequate resources to repay its debt holders, bond insurance will typically guarantee payment of interest and principal on municipal bonds.
- Economic downturn/recession: In the event of an economic downturn, which could be regional or national, municipalities can face the impact to its tax base in the form of layoffs or closure of businesses. In the event of an economic downturn and the municipality’s inability to meet its debt service, the bond insurer will likely make the debt service.
- Administrative errors, fraud or other interruptions: Many bond insurers will also cover missed payments related to administrative errors, political disputes, or cyber attacks.
Check out this article to see you can evaluate bond insurers.
The Bottom Line
For both investors and issuers, municipal debt insurance can lower the portfolio risk and help to mitigate the economic uncertainties to an extent. It’s important to note that every debt issuance is unique and can have a level of insurance through a bond insurer. Therefore, it’s important for investors to review the official statement and credit rating analysis on any debt instrument before deciding on the investments.
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