Does Bond Insurance make sense for you?
Editor's note: This article is based on a report by the California Debt and Investment Advisory Commission entitled "Bond Insurance as a Form of Credit Enhancement in California's Municipal Bond Market." The full report can be ordered from CDIAC by phone at 916/653-3269 or downloaded from the Internet at www.treasurer.ca.gov/cdiac.
By transferring investor risk from the debt issuer to a third party, credit enhancement can improve credit ratings on bonds thereby lowering the issuer's borrowing costs. The use of credit enhancement by state and local governments has steadily increased since New York City's well-publicized financial difficulties and the $2.25 billion default by the Washington Public Power Supply System--events that shook investor confidence in municipal securities. (1) In California, approximately half of the total debt issued in 2000 was credit-enhanced. More than 85 percent of the debt enhanced by California issuers in 2000 was covered by bond insurance, which is the most common form of credit enhancement for long-term, fixed-rate obligations.
The use of bond insurance has both benefits and drawbacks. As such, municipal bond issuers must take into account many different factors when considering this type of credit enhancement. The purpose of this article is to familiarize public issuers with the basics of bond insurance, particularly those issuers who are infrequent participants in the bond market or who have never used credit enhancement. After explaining the types of credit enhancement, the costs and benefits of bond insurance, and the mechanics of bond insurance, the article concludes with a framework that issuers can use to decide whether bond insurance is appropriate for them.
Types of Credit Enhancement
The two most common types of credit enhancement in the municipal bond market are bond insurance and letters of credit. Bond insurance is an insurance policy that guarantees the timely payment of scheduled principal and interest over the life of the insured bonds. A letter of credit is an irrevocable contract between a commercial bank and a bond trustee or fiscal agent in which the bank typically pledges to draw on the letter when necessary to make required principal and interest payments if the issuer cannot do so. Letters of credit typically are used for variable rate bonds. Used to a much smaller extent than bond insurance and letters of credit, other types of credit enhancement include lines of credit, mortgage insurance, and private guarantees.
Costs and Benefits of Bond Insurance
Issuers should compare the costs of obtaining insurance to the benefits derived from using bond insurance. The costs of bond insurance (premium costs and the costs of meeting insurer requirements) usually are paid up front, whereas the benefits (interest savings and increased marketability) accumulate over the life of the bond. Therefore, it is important that the present value of the benefits be greater than the present value of the costs.
Insurance premiums reflect general market conditions for bonds of different credit quality, as well as the degree of risk perceived by the insurer in adding a particular issuer's bonds to its portfolio. The premium cost of purchasing bond insurance varies depending on the insurer's evaluation of the issuer's credit, the complexity of the transaction (revenue bonds and lease transactions, for example, typically require more analysis than general obligation bonds), and market competition. Insurers also consider the cost of the capital that they must charge to each transaction in order to properly manage their resources and maintain their AAA ratings. According to Standard & Poor's, average municipal bond insurance premiums increased 9.8 percent to about 45 basis points in 2000, compared to the average premium of 41 basis points in 1999.
Premiums are not the only costs associated with bond insurance. Insurers often impose a number of requirements on issuers before qualifying bonds for insurance. The costs of complying with such requirements, which often extend through the life of the bonds, should be taken into account and balanced against potential interest savings. Examples of insurer requirements include net revenue coverage or additional bonds tests, reserve reinvestment limitations, greater capitalized interest, construction contingencies, hazard insurance, and rental/business interruption insurance.
To assess the cost-effectiveness of purchasing bond insurance, issuers also should be able to quantify its benefits. The most significant benefit of bond insurance is interest savings--the "spread" between an insured and an uninsured bond. Interest savings can be determined by subtracting the average yield for a bond for a given credit rating and maturity from that of an insured bond of the same maturity.
In 2000, the spread between the average AAA-rated insured bond and the average A-rated uninsured bond ranged from 8 to 13 basis points, depending on maturity. The spread between a AAA-rated insured bond and a BBB-rated uninsured bond was even more significant--39 to 57 basis points. Bond insurance does nor always result in interest savings. For example, spreads for uninsured AAA-rated and AA-rated bonds were negative, meaning that the insured bonds actually had higher yields than the uninsured bonds. Consequently, bond insurance probably does not make economic sense for bonds with an underlying rating of AA or better. It may not be justified for lower-rated bonds either, once all the other relevant costs and benefits are factored into the analysis.
Issuers also must consider how the marketability of a bond reduces the yield demanded by investors. A bond's marketability is affected by its perceived credit risk and liquidity risk (see Exhibit 1 for definitions of these terms). Insurance mitigates these two forms of risk by transferring them from the investor to the insurer, thereby enhancing the marketability of the bonds. Bond insurance also may alleviate investor concern about complex financings because it provides a commonly understood means of evaluating their credit quality. Since repayment is guaranteed irrespective of the unusual structure of the transaction, the bonds retain their marketability.
The Mechanics of Bond Insurance
Once a government has decided to consider bond insurance, the next step is to seek a bond insurance company. There are four major AAA-rated monoline municipal bond insurers in terms of total par value of obligations insured, each specializing in a different area. The major insurance companies are Ambac Assurance Corporation, Financial Guaranty Insurance Company, Financial Security Assurance Inc., and Municipal Bond Investors Assurance Corporation. There are also a number of specialty insurers that focus on lower-quality, low-rated, or non-rated debt not considered by the four major firms.
Bond insurers can be differentiated by a number of factors, including the par amount of insurance written, exposure, assets, and capital adequacy (Exhibit 2). Standard & Poor's capital adequacy model projects financial results under stressful economic circumstances by calculating a margin of safety that relates total claims-paying resources to losses. For example, a margin of safety of 1.25 signifies that an insurer has the ability to pay expected losses one and a quarter times over. The minimum margin of safety for AAA-rated bond insurers is 1.25. The minimums for AA- and A-rated insurers are 1 and .8, respectively.
The underwriting criteria used by bond insurers to evaluate credit quality differ by bond type and include the economic, financial, socio-political, and structural factors of the issue itself, as well as the demographics, revenue and financial history, and overall financial condition of the issuer. All AAA-rated firms subscribe to "zero loss" or "remote loss" underwriting standards intended to insure mostly securities carrying a low risk of default. By focusing on credits with low credit risk, AAA-rated insurers can minimize their claims experience. To further insulate themselves against loss, insurers typically set conservative limits on risk for individual and aggregate securities, and diversify their portfolios by sector and by geographical region.
Bonds under consideration for insurance are reviewed not only by insurers, but also by one or more rating agencies. Under certain circumstances, it may make sense to obtain an "underlying" rating prior to or while seeking to qualify for bond insurance. Knowing the underlying rating can help in evaluating the costs and benefits of bond insurance. In addition, a high underlying rating (i.e., a rating in the A category) can improve the marketability of an insured bond. The opposite is also true, however; an insured bond with a low underlying rating may trade at higher yields than other insured bonds. As a result, issuers expecting low underlying ratings sometimes forego this step. This option is not always possible, however, since insurers may require issuers to obtain underlying ratings when their creditworthiness is in doubt. The cost of obtaining ratings is the responsibility of the issuer, not the insurer. Ratings based solely on the insurer's ratings cost less than those that include an underlying rating.
The actual process of purchasing bond insurance depends on whether an issue is sold through a negotiated or a competitive sale. (2) In a negotiated sale, the issuer consults with its underwriting team to decide whether or not to insure the issue. This decision is typically made just prior to the sale of the bonds or, in many cases, on the day of the sale. The latter scenario is especially likely when only selected maturities are cost-effective to insure. In a competitive sale, the issuer either decides to buy insurance, makes arrangements to qualify the issue for insurance and then lets the bidders buy it if they choose, or requests bids for both insured and non-insured issues. Once the bonds have been sold, investors also can purchase bond insurance tailored to their particular needs.
Public issuers should consider several key factors in deciding whether or not to insure a bond issue. These factors, which are summarized in checklist format in Exhibit 3, are discussed below.
Decide Which Type of Credit Enhancement Best Suits the Situation
The various types of credit enhancement, including bond insurance, letters of credit, lines of credit, mortgage insurance, and private guarantors, each have their place in the municipal bond market. Although bond insurance is the most common type of credit enhancement, the other types may be more appropriate depending on the circumstances.
Know What Insurers Consider in Evaluating Applicants
By knowing the insurers' underwriting criteria, issuers can determine whether a given transaction is viable. For instance, specialty firms target low investment grade and high non-investment grade issues. If an issue is in this range, it might be beneficial to talk to one or more specialty firms. In evaluating insurance applications, insurers consider the economic, financial, socio-political, and structural factors of the issue itself, as well as the demographics, revenue and financial history, and overall financial condition of the issuer.
Approach the Bond Insurers
Issuers should research specific insurers to determine which company best meets their needs. To this end, issuers need to compare the characteristics of the transaction with the specialties of the various insurers. By approaching insurers that specialize in certain types of transactions or that are seeking to enter a particular market, issuers may be able to obtain discounted premiums. When the transaction meets the underwriting criteria of the major monoline insurers, issuers should obtain approval and premium quotes from all four of these companies in order to secure the best possible deal. An "exclusive" approach may be beneficial in some cases, especially when time is of the essence or when an insurer is offering attractive incentives.
Perform a Cost-Benefit Analysis
Ultimately, the decision to purchase bond insurance comes down to cost effectiveness. As such, issuers must accurately determine whether it makes economic sense to enhance an obligation by performing a cost-benefit analysis. If the present value of the interest savings and increased marketability is greater than the present value of the premium costs and insurer requirements, then purchasing bond insurance makes sense. (3) This analysis should be performed for both the issue as a whole and for specific maturities. On occasion, it may make sense to insure only specific maturities of an issue.
Determine the Most Appropriate Method of Obtaining Bond Insurance
Depending on the circumstances, issuers may need to decide on a method of purchase. For a competitive sale in which the potential benefits of insurance are uncertain, issuers can rely on a bidder's option or multiple bid approach with appropriate bid parameters to meet its needs. In a negotiated sale, issuers should consult with their underwriters near the time of pricing to determine whether to insure the issue (or portions thereof). Alternatively, the purchase of bond insurance can be left up to the individual investors in the secondary market.
According to Standard and Poor's, the domestic municipal bond insurance market is likely to continue cyclical growth swings in the future. Overall, though, the industry is expected to remain strong as solid capital adequacy measures provide a good buffer should claims increase during the current economic downturn. In addition, the premium pricing discipline exhibited over the last two years is not expected to be abandoned.
Before purchasing bond insurance, government issuers need to determine whether or not it is in their best interests to do so. This article is intended to assist issuers in making this determination by familiarizing them with the basics of bond insurance, including the various types of credit enhancement, the costs and benefits of insuring bonds, and the process of obtaining bond insurance. The step-by-step process outlined in the last section can serve as a useful framework for governments as they analyze the appropriateness of insuring their obligations.
Exhibit 2 SELECTED FINANCIAL INFORMATION FOR MAJOR MONOLINE BOND INSURERS (As of December 31, 2000) $ Millions AMBAC FGIC Net par exposure $276,252.0 $150,624.0 Net par written $65,303.0 $22,661.8 Total assets $4,473.4 $2,651.8 Statutory capital $2,735.9 $1,913.4 Net income $338.3 $168.6 Losses and loss-adjusted expense $8.6 ($0.3) Average premium rate 63b.p. 20b.p. Margin of safety 1.3-1.4 1.5-1.6 Capital remaining at end of $1,700-1,750 $1,150-1,200 depression test $ Millions FSA MBIA Net par exposure $154,019.8 $418,443.0 Net par written $47,794.8 $85,260.0 Total assets $2,228.8 $7,629.3 Statutory capital $1,436.7 $4,505.0 Net income $113.8 $543.9 Losses and loss-adjusted expense ($0.8) $24.6 Average premium rate 36b.p. 53b.p. Margin of safety 1.5-1.6 1.3-1.4 Capital remaining at end of $1,050-1,200 $1,950-2,000 depression test
(1.) James C. Joseph, "Credit Enhancements" in Debt Issuance and Management: A Guide for Smaller Governments (GFOA: Chicago, 1994), 97.
(2.) For an explanation of methods of sale, see California Debt and Investment Advisory Commission Issue Brief Number 1, Competitive vs. Negotiated Sale of Debt, www.treasurer.ca.gov/cdiac.
(3.) For more information on performing a cost-benefit analysis, see R. Gregory Michel, Decision Tools for Budgetary Analysis (GFOA: Chicago, 2001) 55-66.
RELATED ARTICLE: Exhibit 1
CREDIT AND LIQUIDITY RISK DEFINED
Credit risk is the potential loss from an investment as a consequence of an issuer's failure to make principal and interest payments to investors in full or on time. Investors of insured bonds are insulated from credit risk because they can depend on the insurer to make timely payments of scheduled principal and interest.
Liquidity risk is the risk that an investor may not be able to sell a security in the secondary market quickly and at competitive prices. For example, if an issuer encounters financial problems and the rating on its security is downgraded, the market value of the bonds likely will decline. Such a decline in market value could cause secondary market liquidity problems because other investors may not want to assume the risk of purchasing the securities for fear of further declines in value. Investors of insured bonds are insulated from liquidity risk because the value of the bonds relies on the rating and financial condition of the insurer.
Exhibit 3 DECISION-MAKING CHECKLIST Decide which type of credit enhancement best suits the situation Bond insurance * Letter of credit * Line of credit * Mortgage insurance * Private guarantee * Know what the insurers consider in evaluating applicants Underlying rating * Underwriting criteria * Limits on single and aggregate risk * Sector and geographical diversification * Approach the bond insurers Compare characteristics of transaction with specialties of insurers * Consider approaching all of the insurers if the transaction fits their criteria * Consider an "exclusive" approach if time is of the essence or the insurer is offering attractive incentives * Perform a cost-benefit analysis Costs * Premium costs * Insurer requirements * Benefits * Interest savings * Increased marketability * Determine the most appropriate method of obtaining insurance Negotiated sale * Insured * Non-insured * Competitive sale * Buy bond insurance prior to sale * Qualify and allow bidders to purchase insurance * Request bids for both insured and non-insured bonds the insurer *
FRANK MOORE is a research program specialist for the California Debt and Investment Advisory Commission in Sacramento. His current research focuses on public debt issuance, specifically, credit enhancement and disclosure. Prior to joining CDIAC two years ago, Moore worked for California's educational and health facilities financing authorities, providing analysis and interpretation of financing applications from public and non-profit health and educational facilities. He holds a bachelor's degree in economics from the University of California-Berkeley and an MBA from California State Polytechnic University in Pomona.
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|Publication:||Government Finance Review|
|Date:||Aug 1, 2002|
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