What it means
Many municipal bonds, which are bonds issued by local governments, schools and public authorities, carry bond insurance. The insurer promises to pay interest and principal if the issuer cannot, and the bond usually takes the insurer's higher rating as a result.
This makes borrowing cheaper for the issuer. Insurance can hide the real quality of the issuer.
S&P therefore publishes an underlying rating, abbreviated SPUR, which assesses the issuer's own ability to pay without the insurance. The difference between the two ratings shows how much the insurance is adding.
Investors found this information particularly important after the financial crisis of 2008, when several large bond insurers were downgraded sharply and bonds that relied on them lost their high ratings. Those who had looked at the underlying rating were better prepared for the change.
The rating is helpful to anyone assessing local government risk, including banks that lend to public bodies and finance officers at councils or school districts. A strong underlying rating signals that the issuer can stand on its own, while a weak one shows that the insurance is doing most of the work.
When reading a bond's rating, check whether it is the enhanced rating (with insurance) or the underlying one. The two can differ by several notches, and the price and yield on the bond depend on the one the market trusts.
Municipal finance teams also use the underlying rating when planning future borrowing. An issuer that has a strong rating by itself pays less for insurance, or may not need it at all, and can save money on every new bond issue.
An issuer with a weak rating can use the same information to see which improvements, such as building reserves, would raise the grade.
In practice
Real-world examples.
Example
A county issues $50,000,000 of bonds backed by an insurer rated AAA, and the bonds are rated AAA as a result. S&P's underlying rating for the county is A, which shows what the market would face if the insurer failed.
Example
A bank treasurer buys municipal bonds for the bank's investment portfolio. She reviews the underlying rating to make sure each issuer meets the bank's internal credit standards without relying on insurance. The bank's policy sets a minimum underlying grade for every holding.
Example
A school district finance officer asks an adviser why the district's borrowing costs are higher than a neighbour's. The adviser points out that the neighbour's bonds carry insurance while the district's bonds are priced on its underlying rating alone. He suggests that building a larger reserve fund could raise the underlying grade over time.
Formula
Calculation
Not applicable. The difference in notches between the two grades is a rough measure of how much credit support the insurance provides.Case study
Seen in the real world.
Riverbend Water Authority is an entirely fictional public body that wants to borrow $20,000,000 to replace ageing pipes. In this illustrative story, its own underlying rating is BBB+, which would make borrowing fairly expensive.
The authority buys bond insurance from a highly rated insurer for a one-time fee, and the bonds are rated AA as a result. The interest saving over 20 years is larger than the insurance cost, so the purchase makes financial sense.
Years later the insurer is downgraded and the bonds fall to the underlying rating of BBB+. The illustrative lesson is that insurance is a useful tool but investors and issuers should always look at the underlying strength. The authority's board adopted a policy of publishing the underlying rating alongside the insured rating in every offering document, so that buyers could see both figures. It also began building a debt service reserve to improve its own rating, with the aim of needing less insurance on future borrowing. Because the underlying rating was published from the start, residents and the board are not surprised when the bonds trade down.
Watch out
Common mistakes.
- Reading the insured rating on a bond as the issuer's own credit strength.
- Assuming insurance is permanent, when the insurer's rating can fall or the insurer can be replaced, merged or taken over by regulators.
- Ignoring the underlying rating when buying insured bonds, which leaves the buyer unaware of how much the price depends on the insurer.
Questions
People also ask.
What does SPUR stand for?
It stands for Standard & Poor's Underlying Rating, and it is shown separately from the enhanced rating on the same bond.
Why is the underlying rating lower than the insured one?
Because the insured rating reflects the insurer's stronger credit, while the underlying rating reflects the issuer alone, so the gap shows how much support the insurance gives.
Is the underlying rating used outside municipal bonds?
It is mainly used there, although the same idea applies to any guaranteed debt, such as bonds backed by a parent company or a government guarantee.
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