Future of Bond Insurance at Risk

By | December 27, 2007

The biggest casualty of the crisis surrounding bond insurers may well be the insurers themselves.

Issuers and bond buyers alike may find it easier now to dispense with insurance, experts say, given that the finances of industry players like ACA Capital and MBIA Inc. have come under strain.

“It may not be that important in today’s market to get bond insurance,” said R.J. Gallo, a portfolio manager at Federated Investment Management Co. who specializes in the muni market. “People now realize that there are plenty more buyers for munis than was realized. The market is now broad and deep and even if issuers have to give a bit more, they will be able to get their capital.”

The “muni bond” market creates funds for such vital projects as sewage treatment systems, library expansions, sports facility overhauls and dam constructions. About $1.7 trillion worth of municipal bonds issued by more than 50,000 entities are currently held by investors, according to the Securities Industry and Financial Markets Association.

In general, bond issuers pay extra for the insurance, but in better times the financial strength of the insurer allowed the issuer to sell the bonds with lower interest rates.

Most bond insurers carried excellent ratings until recently, and these companies were able to pass those strong ratings to the local entities they insured. This gave instant credibility to obscure borrowers like local school districts and road-paving projects.

But recent disclosures about the insurers’ strained finances and uncertain ratings prospects put the value of bond insurance in question.

Many cities, counties and states have excellent track records of avoiding default and may conclude they don’t need the extra backing or the extra expense of insurance, said John Flahive, director of fixed income for BNY Mellon Wealth Management.

On the other hand, nonprofit institutions like local museums and school districts with little history of issuing bonds are likely to end up paying higher premiums to investors. But they should be able to find investors to sell their bonds to without insurance if they are willing to grant more attractive terms, according to John Nelson, a managing director in Moody Investors Service’s public finance group.

Last week Standard & Poor’s downgraded ACA, a relatively small bond insurer, to junk status, making it unlikely ACA will be able to insure any more bonds. Previously ACA held an investment grade “A” rating. And Fitch Ratings has put Ambac Financial Group Inc. and MBIA on warning that the insurers must raise fresh capital or face downgrades.

Only about half of muni issuances are insured and if more credibility problems surface, the proportion could fall further, experts said. For instance, this week there is greater demand in the municipal market for uninsured bonds than insured debt, said BNY Mellon’s Flahive.

“We existed a long time without municipal bond insurance, and we could continue to do so,” Flahive said. He noted that local U.S. governments and institutions have been issuing debt for centuries, but bond insurance only dates back to around the 1970s.

In addition, the need for bond insurance in the muni market also may be undermined by the sector’s low default rate, which makes them superior to corporate debt in some investors’ view.

Gail Sussman, a managing director at Moody’s who analyzes government credit, said it is possible that in the current environment state and local government issuers “could issue on their own, without any ‘wrap’ (bond insurance), if the ‘wrap’ does not make economic sense.”

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