The role of municipal bond insurance continues to decline in the municipal market, with insured bonds comprising only 11% of year-to-date new issuance through July.
- Ambac, one of the largest bond insurers, was downgraded further into “junk” territory in July, and of the ten municipal bond insurers, only three maintain a financial strength rating of AA or higher.
- Some positive news may lie on the horizon for investors seeking the highest rated municipals bonds, but it is unlikely insurance will return to the pre-crisis role it played in the municipal market.
- While the diminished role of insurance is a negative, we believe it is not enough to offset positive aspects driving performance of the municipal bond market.
The role of bond insurance continues to decline in the municipal market, with insured bonds comprising only 11% of year-to-date new issuance through July. Prior to the start of the financial crisis in 2007, municipal bond insurers backed roughly half of the entire municipal market. In 2008, municipal bond insurers began to lose their AAA ratings status, as projected losses on complex mortgage-backed securities led to downgrades from both Moody’s and S&P. For bond issuers, insurance from a company with less than a AAA rating offered little value. The percentage of newly issued insured bonds dropped to 18% in 2008 and to 11% so far in 2009 according to Bloomberg.
More Junk in the Municipal Realm
Negative headlines continued in July as Ambac, one of the four largest bond insurers, was downgraded further into “junk” territory. Ambac’s ratings were reduced to Caa2 by Moody’s and to CC by S&P, and the downgrades have forced the company to postpone plans to separate its municipal insurance business from its structured mortgaged-backed securities business into a new, more viable company. Of the major municipal bond insurers, only three maintain a rating of AA or better. In table 1, “Credit Watch” indicates a possible rating change in the coming weeks or months; “Outlook” indicates the likely longer-term ratings direction over the next six to twelve months; and “Developing” implies that any change (positive, negative, or none) is possible.
Moody’s has taken a particularly harsh path towards the municipal insurers, stating that a municipal-only insurance model is not viable. Although the ratings agency’s reasoning has been less than clear and perhaps politically motivated, Moody’s believes a AAA-rating is unobtainable for any company given the uncertainty inherent in their business models.
Market impact from negative news, such as the Ambac headlines, has become more muted in 2009. Most insured bonds were already trading in relation to their underlying ratings. The insurers actually took great care with their municipal business (unlike their mortgage business in many cases) and focused on higher quality issuers. Roughly 90% of insured bonds carry an underlying rating of A or better, so insurer downgrades below A have caused fewer corresponding bond downgrades. So although Ambac’s downgrade did result in some subsequent bond downgrades, the ratings on the majority of Ambac insured bonds were unaffected. An insured municipal bond is rated at the higher of the insurer’s rating or its underlying rating (the rating based solely on the municipality’s credit profile).
What’s next for Municipal Bond Insurance?
Since there is no economic value from bond insurance unless it results in at least an A rating for the bond, many of the insurers rated below BBB are now in “runoff” mode. In runoff, the insurers do not underwrite new business (as is the case with Ambac) and simply collect money on insurance premiums already written. Over several years, the insurer hopes that premiums will be enough to offset potential losses on all claims and then attempt to reestablish the business or simply return any excess proceeds to equity and/or bond holders.
An insurer is still liable to pay claims (i.e., a default or missed interest payment) even if in runoff, since they maintain some claims paying ability. Given the potential mountain of claims against the existing capital base (particularly from those subject to sub-prime mortgage exposure), it is uncertain whether these insurers will be able to meet future claims. A bond insurer is required to make up any missed interest payments, but principal repayment, in the case of default, is not made until maturity or until bankruptcy is resolved, whichever comes first.
A potential new insurer and possible new federal legislation could be positive developments for investors seeking the highest quality municipal bonds. Municipal and Infrastructure Assurance Corporation (MIAC), backed by investment bank Macquarie Group and private equity firm Citadel, is attempting to enter the market over coming months as a AAA-rated, municipal bond only insurer. Increasing the pool of AAA-rated bonds would bring in more investors to the municipal market.
The House Financial Services Committee has proposed two bills to be voted on this fall that could affect municipal bond ratings:
- The Municipal Bond Fairness Act would require the rating agencies to rate municipal bonds more consistently with other bonds, such as corporate bonds. Since investment grade municipal bonds have exhibited a much lower default rate than comparably rated corporate bonds, this requirement could result in one to two-notch upgrades for thousands of municipal bonds. Moody’s was set to implement such a plan last fall but indefinitely postponed the implementation due to the credit crisis and recession.
- The Municipal Bond Insurance Enhancement Act would create a federal financial guarantor to reinsure bonds backed by municipal only insurers. However, the proposed dollar amount of $50 billion is relatively small and could have a limited impact.
Even if these events come to fruition, we don’t expect bond insurance to return to its pre-crisis status. The municipal bond market continues to forge ahead regardless.
We think the rally in municipal bonds will continue, even with insurance questions lingering, but at a more gradual pace. The diminished role of municipal bond insurance is one reason why municipal valuations remain cheap by historical norms despite the impressive rally so far this year. Even without insurance however, high quality municipal bonds have exhibited very low default rates. The municipal market continues to benefit from a favorable supply-demand balance, attractive valuations, and the prospect of higher tax rates. Taken together these factors should outweigh insurance woes. On a longer-term basis, the expiration of the Bush tax cuts in 2010 alone could more than offset the lack of insurance and be a catalyst to still higher municipal bond valuations.
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