Municipal bond insurance protects investors who purchase bonds issued by government agencies. Issuers buy insurance to raise the bond’s rating, making it more attractive to investors. Insurance companies only insure entities with a strong investment grade credit rating.
Municipal bond insurance provides protection to investors who have purchased municipal bonds, or munis, issued by state, municipal, and government agencies. The bonds are debt instruments sold to raise the capital required to finance various public projects, including infrastructure, schools, and housing developments. Many municipal bond issuers also use many of the projects they finance to create income streams. Issuers buy municipal bond insurance to raise the bond’s rating, making it more attractive to investors.
MGIC Investment Corporation formed the first municipal bond insurance company in the United States in 1971. Until that time, government bond offerings were rarely insured. In 1975, the near bankruptcy of New York City caused many investors on Wall Street to worry about the consequences of the city’s default on its bonds. When a large Pacific Northwest utility, Washington Public Power Supply, failed to meet its $2 billion dollar outstanding bond payments in 1983, pressure for insured municipal bonds began to mount. These incidents highlighted the increased vulnerability of investing in municipal bonds.
Internationally, the municipal bond market has not developed as it has in the United States. Although Canada is the second largest issuer of municipal bonds outside the United States, municipal bond insurance plays a minor role as bonds issued by municipalities are guaranteed by the Canadian Municipal Finance Corporations. Over the past decade, the European municipal bond market has experienced growth. Some of the largest US municipal bond insurers have even opened international offices or formed joint ventures to help insure issues. However, most infrastructure projects and other public works are still financed mainly by banks that specialize in municipal financing.
There are basically two types of bonds issued by government and agency entities: general obligation bonds and revenue bonds. General obligation bonds are generally paid for with income and taxes. The assets are not used to guarantee general obligation bonds. Principal and interest payments due on the revenue bonds are paid from receipts generated by the project financed by the bond issuance, such as toll bridges and sports stadiums.
Issuers purchase bond insurance to raise the credit rating of their municipal bonds to triple A. The issuer’s credit rating is not the most important factor in rating municipal bonds. The profit earned by bond insurers is the lower interest rate they generally pay bond buyers. Investors will generally accept a lower return on their investment principal in exchange for guaranteed interest payments. Buyers also prefer the security of their principal that municipal bond insurance offers.
If the issuer of the bond defaults, the insurance company that issued the policy will make the interest payments as due. As promised, the principal will be paid on the bond’s maturity date. If the municipal bonds are contained within an investment trust, the insurance is good for the life of the bonds or the life of the trust. Municipal bond funds may also carry bond insurance. Municipal bonds generally must be rated BBB or higher to qualify for municipal bond insurance.
Insurance companies will only insure entities with a strong investment grade credit rating. Most municipal bond insurers have a team of municipal bond experts, including credit analysts, attorneys, and municipal bond financing professionals. These individuals are well trained in all aspects of assessing the stability and solvency of bond issuers. Areas that are typically analyzed typically include revenue, disbursements, and the state of the regional economy. Experts may also consider the tax base as well as the overall financial strength of the issuer.
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