In this article, we will look at the evolution of the municipal bond market and the top five reasons why issuers and investors should choose insured versus uninsured bonds.

The first bond insurer appeared in the early 1970s to help municipalities and public entities seek better access to cheaper funding. City or state governments pay a modest fee to insure their bonds in order to improve their credit rating and marketability. For a long time, it was generally assumed that bond insurers would almost never sustain a loss for guaranteeing timely principal and interest payments of a municipal bond because municipal defaults are so rare and, in any case, an issuer is obligated to reimburse any claims paid by the insurer.

In recent years, the municipal bond market has witnessed several highly publicized defaults, including those related to Detroit’s $18 billion bankruptcy and, more recently, Puerto Rico’s $72 billion of outstanding debt. Some of the defaulted bonds were general obligations, theoretically supported by the unlimited taxation power of the respective municipalities, but the issuers created a ruckus for bondholders by choosing whom to pay or not. As a result, municipal bonds started looking less like government debt (i.e., Treasuries) and more like conventional credit-focused corporate bonds.

The need for bond insurance becomes all the more relevant under such a scenario. On top of that, municipal bond insurers are now a completely different beast, having learned the hard way from the 2008 credit crisis. Today these insurers are a lot more selective about the type of obligations they insure and avoid the non-municipal exposures that caused them losses during the recession, such as mortgage-backed securities. They have always required that obligations they insure be investment grade, but municipal bonds must also be in sectors and meet other credit standards the guarantor approves.

The benefits of bond insurance for investors have become painfully apparent in Puerto Rico, where certain scheduled payments on uninsured bonds have not been made, while highly rated bond insurers made full and timely payments on bonds they insure when the issuer failed to pay.

A Second Layer of Security Against Default

The most widely known benefits of bond insurance are simply the insurance against default and the timely payments of principal and interest. For instance, Puerto Rico defaulted on more than $2 billion in bond payments on July 1, which sent bond prices sharply lower. Bond insurers stepped in and continued making payments on insured bonds, while uninsured bondholders are subject to an indefinite hold on payments until the Commonwealth’s issues are sorted out.

Added Due Diligence

Municipal bonds are notoriously difficult to research. Fortunately, bond insurers provide an added level of due diligence that can help simplify the process. This due diligence includes everything from assessing credit risks to ensuring that bond issuers meet their sinking fund provisions on a timely basis. Issuers are also incentivized to keep everything in line to avoid any potential litigation from well-capitalized bond insurance companies.

Better Stability to Prices & Yields

Bond insurance helps stabilize bond prices and yields by keeping the credit profile more consistent over time. For example, Moody’s downgraded the City of Chicago in May 2015 to Ba1 (its highest junk-bond rating), which caused uninsured 10-year bond prices to fall nearly 8% over the course of the week. But the city’s insured bonds remained valued at slightly above $1,000 during that period, which kept their yields steady, as insured investors saw no reason to sell.

Enhanced Market Liquidity

It is difficult for investors, especially individual investors, to evaluate specific bonds, and the market for many names can be thin, making it difficult to sell a bond readily. Bond insurance tends to make insured bonds more homogeneous, allowing buyers to focus more on yields, terms and maturities than on the underlying credit. On average each week, $3 billion or more of bonds guaranteed by the small number of insurers change hands.

Better Perception Compared to Credit Ratings

Bond insurers are widely viewed as better than credit rating agencies at evaluating and monitoring the creditworthiness of an issuer. Of course, bond insurers also have a lot more at risk than credit agencies, which aligns the insurers’ incentives with those of bondholders. As a result, many investors tend to trust bond insurers with analyzing credit risks more than credit rating agencies.

It’s not just investors who stand to benefit from bond insurance, but also the issuers issuing these bonds. There are many reasons that issuers may want to insure bonds, but most reasons boil down to improving marketability and reducing the cost of issuance.

Improved Marketability

Small issuers may require bond insurance to attract investment. For example, a large A-rated municipality could easily issue hundreds of millions of dollars’ worth of bonds knowing that institutional buyers will conduct their own due diligence. But a small school district issuing less than $10 million in bonds may need a bond insurer to provide some level of due diligence for investors and make the issue more marketable to the public.

On similar ground, issuers with a shaky credit profile, arising from budgetary issues or past defaults, may require some form of credit enhancement to draw investors. Bond insurance is a great way to improve a bond’s credit rating by guaranteeing timely repayment, which makes selling the bonds to individual and institutional investors a lot easier. For example, to help resolve Detroit’s fiscal crisis, bond insurers guaranteed portions of a refunding issue used to reduce the debt load of Detroit’s water and sewer authority.

Then there are bonds that may appear attractive to issuers but investors may require some reassurance. For instance, President Trump’s $1 trillion infrastructure policy may be highly supportive of infrastructure bond issuers, but investors may require bond insurance due to their distrust of the plan being executed by the president. These issues may seem creditworthy from the surface but political risks could jeopardize them in the future. A case in point: Build America Bonds suffered a reduction in federal subsidies as a result of the sequestration that followed the failure of Congress to enact a deficit reduction plan in 2012.

Finally, there is the case of revenue bonds, which are not backed by taxing power but instead rely on a revenue stream produced by the payments for a specific service, such as providing electricity or water. As actual usage determines the future revenue stream, issuers may want to provide a backup for bondholders in the event that service revenues unexpectedly fall and are insufficient to cover bond payment obligations. This can make these bonds more palatable for investors while making the bond issuance less expensive at the onset.

Vote of Confidence

Bond insurance is a vote of confidence in an issuer’s ability to repay debt. This kind of support may be helpful for smaller, less well-known issuers or in cases where municipalities that have successfully resolved well-publicized fiscal challenges have a hard time convincing investors that things have changed for the better.

Lower Costs

Bond insurance generally increases a bond’s credit rating since the insurer is typically rated more highly than the issuer. Since there’s less risk of default with a backup payor, issuers pay less of a risk premium and interest costs over time. The amount of savings depends on the credit rating and associated yield of the bond without insurance, compared with the yield of the bond with insurance, while factoring in the cost of securing bond insurance.

For example, a municipality issuing a 25-year, $100 million bond that, uninsured, would have a single-A credit rating and a 4.0% yield may use bond insurance to increase the bond’s credit rating to AA with a 3.75% yield. The net interest savings over the life of the bond would have a present value of about $2 million even if the cost of insurance equaled that amount.

Bond insurance is a great way for issuers to improve marketability and lower costs while providing bondholders with greater reassurance and predictability. As investors digest the lessons of Detroit, Puerto Rico and other troubled credits like Chicago and Atlantic City, bond insurance is sure to play a bigger role in the municipal bond market over time and help to ensure its smooth operation.

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.