What it means
The economics are straightforward: an issuer is buying a better credit rating. A borrower rated in the middle of the investment grade range pays a higher yield than one rated at the top, and if an insurer with a stronger rating guarantees the payments, the bonds are priced closer to the insurer's credit quality than to the issuer's own.
Insurance makes sense whenever the interest saved over the life of the bond exceeds the premium. The product is most common in municipal bond markets, where large numbers of small issuers, such as school districts, water authorities and transport agencies, come to market with names investors have never analysed.
A guarantee from a recognised insurer saves those investors the work and widens the pool of buyers, which itself helps pricing. The premium is normally a one-off payment made at issue, quoted either as a percentage of the principal or as a percentage of total debt service over the bond's life.
Because it is paid upfront and the saving arrives year by year, the decision is a straightforward comparison of a known cost now against a stream of savings later. The critical nuance is that the guarantee is only as good as the insurer.
If the insurer is downgraded, every bond it has guaranteed effectively reverts to the issuer's own credit standing, and prices fall accordingly. This is why analysts look at both the insured rating and the issuer's underlying rating, and why concentration in a small number of insurers is itself a risk factor.
Insurance also changes what happens in a default rather than preventing one. The insurer steps in to make the scheduled payments, so bondholders continue to receive their money on schedule, and the insurer then pursues the issuer for recovery.
Bondholders avoid the cash flow interruption, but the underlying financial problem still exists.
In practice
Real-world examples.
Example
A rural school district with no credit history of its own buys insurance on a $15 million bond issue. The guarantee gives the bonds a top tier rating, and the issue is oversubscribed by investors who would otherwise have skipped an unfamiliar name.
Example
A city bridge authority compares quotes and finds the premium would cost more than the interest it would save, because its own rating is already strong. It issues uninsured and saves the premium entirely.
Example
An investment committee holding insured municipal bonds notes that the insurer has been placed on negative credit watch. It reprices the holdings on the issuers' underlying ratings rather than the insured ratings, and trims two positions where the underlying credit is weak.
Formula
Calculation
Annual interest saving = Principal x (Uninsured yield - Insured yield). Net benefit = (Annual saving x Years to maturity) - Upfront premium.
A water authority plans a $20,000,000 bond issue with a 10 year maturity. Without insurance, based on its own rating, investors would demand a yield of 4.10%. With a guarantee from a highly rated insurer, the bonds would price at 3.75%. The insurer quotes a one-off premium of 0.50% of the principal.
Yield saving = 4.10% - 3.75% = 0.35%
Annual interest saving = $20,000,000 x 0.35% = $70,000
Total saving over 10 years = $70,000 x 10 = $700,000
Upfront premium = $20,000,000 x 0.50% = $100,000
Net benefit = $700,000 - $100,000 = $600,000
The insurance is clearly worthwhile on these numbers. If the yield saving had been only 0.05%, the annual saving would be $10,000 and the ten year total $100,000, exactly equal to the premium, so the deal would be a break-even and not worth the administrative effort.Case study
Seen in the real world.
Greyport Harbour Regional Transit is a fictional public transport authority created purely to illustrate this concept. Facing a $25,000,000 issue for depot upgrades, its finance director obtained an insurance quote of 0.45% of principal, or $112,500, against an expected yield saving of 0.30% on a 15 year issue. The arithmetic looked convincing, with an annual saving of $75,000 and a total of $1,125,000 across the life of the bonds.
The authority proceeded, and the pricing worked as expected. Six years later, however, the insurer was downgraded twice in quick succession, and the bonds began trading on Greyport Harbour's own underlying rating rather than the insured one. Existing investors saw the market value of their holdings fall, and the authority found that its next issue attracted less interest than the first.
In this illustrative case the insurance had genuinely saved money on the original transaction, so the decision was not wrong. What Greyport Harbour had not planned for was the reputational and pricing effect of relying on a single guarantor. Its revised debt policy required the underlying rating to be published in every offering document and set a limit on how much of its outstanding debt could depend on any one insurer.
Watch out
Common mistakes.
- Assuming insurance removes credit risk. It substitutes the insurer's credit for the issuer's, so the risk moves rather than disappearing, and it returns if the insurer is downgraded.
- Buying insurance without comparing the premium to the interest saved. When an issuer's own rating is already strong the yield saving can be too small to justify the premium.
- Ignoring the underlying rating when analysing an insured bond. Prudent investors assess both, because the insured rating can vanish while the underlying credit is what remains.
Questions
People also ask.
Who pays the premium, the issuer or the investor?
The issuer pays it, normally as a one-off cost at the time of issue, because the issuer is the party that benefits from the lower interest rate.
What happens if the issuer actually defaults?
The insurer makes the scheduled interest and principal payments to bondholders on time and then pursues the issuer for recovery itself.
Is bond insurance still widely used?
It is much less common than it was before the financial crisis of 2008, when several major guarantors were downgraded, but it remains in use for smaller municipal issuers with limited name recognition.
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