Municipal bonds are debt instruments issued by state and local governments to finance public projects such as roads and new public buildings. Like other bonds, municipal bonds carry risk that the bond issuer will default, meaning the bond issuer can’t make timely payments of interest and principal. Bond insurance can make a municipal bond issue easier to sell in the marketplace because the insurance provider guarantees investors will be paid their principal and interest if the bond issuer defaults.
No Federal Insurance
The federal government does not insure municipal bonds, even though the government does get into financial insurance. For instance, the government self-insures U.S. Treasury securities with its full faith and credit, and federal agencies insure depositors against the bankruptcy of most financial institutions. But the federal government leaves municipal bond insurance to the private sector.
Muni Insurance Business
Municipal bond insurance emerged as a business in 1971, but bond issuers were slow to take this coverage. According to WM Financial, only 3 percent of bond issues were insured in 1980. But growth came quickly and by 2007, 60 percent of issues were insured and a host of new companies had entered the field. The collapse of the mortgage market and resulting credit crunch in 2008 seriously eroded the financial strength of the entire muni-bond insurance industry and led investors to dismiss the value of bond insurance. By 2012, according to the Wall Street Journal, only about 5 percent of municipal bond issues were insured. But a series of municipal bond defaults in 2012 may lead investors to see municipal bond insurance as desirable once again.
How Insurance Works
Bond insurers tend to be picky about which municipal bonds they will cover because they will be on the hook for payment if the issuer defaults. When a state or local government seeks insurance for a bond issue, the insurance company evaluates the long-term stability of the issuing entity and the risk of default. If the outlook is good, the insurance company issues a policy guaranteeing that investors in the bond issue will be paid their principal and interest no matter what happens to the issuing entity. The insurance company charges a policy premium to the issuing entity or the investment bank that markets the bond issue to investors.
The insurance premium is passed along to investors in the form of lower interest rates on insured bonds. But the lower interest rates can be justified in the marketplace by the increased security against default the bond insurance provides. The bond payment guarantee, however, is only as strong as the insurance company making the pledge. That’s why muni-bond insurers’ financial strength is evaluated by the same credit-rating agencies that rate the bonds themselves. When a bond issue is insured, the credit agencies re-rate the issue based on the insurance company’s ability to pay claims.
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