This was followed by expansion into other asset classes, eventual deterioration in the residential mortgage-backed segment of the non-muni book, a shakeout of all but the strongest financial guarantors, and, finally, a smaller, more focused industry. Through it all, the municipal bond insurance product weathered the challenges and carved out a place in the municipal bond market. It continues to offer cost savings to issuers and meaningful benefits for municipal bond investors.

The basics of municipal bond insurance are straightforward and the logic behind it often quite compelling. Municipal bond issuers, when they bring a new bond deal to market, will sometimes choose to have their bonds insured by a company that specializes in guaranteeing timely payment of principal and interest to investors. Municipal bond issuers will use bond insurance, in the broadest sense, for its ability to increase the appeal of their new bond deals to investors. Making new bond issues more appealing means they can be brought to market with lower yields, thus reducing borrowing costs for issuers.

The appeal of municipal bond insurance for many investors comes from the additional financial support, liquidity, and relative capital preservation a bond insurer can provide. You might say buying insured municipal bonds is like wearing a belt and suspenders.

Investors understand that their insured municipal bonds are first secured by the financial strength of the issuer, but they also appreciate having another source of ultimate security to back that up. They appreciate a municipal bond insurer’s role of stepping into the shoes of an issuer and making principal and interest payments when due to bondholders should that issuer be unable to do so.

Another appeal of municipal bond insurance is the liquidity it can provide for investors. The municipal bond market is vast in size and quite diverse in its issuer names, security types, and bond structures. It is unlikely for many muni bond investors to be familiar with so large a number of issuers but investors could know and embrace the financial strength and record of a few familiar municipal bond insurers. In this way, municipal bond insurance can ease the trading of insured muni bonds and help provide liquidity for investors.

Insured muni bonds can also provide relative capital preservation compared to uninsured bonds from the same issuer. When an issuer’s credit strength deteriorates and is followed by negative market perception and/or outright rating downgrades, insured bonds from that kind of issuer have tended to hold their value to a much greater degree than non-insured bonds from the same issuer.

While municipal bond insurance has been around for quite some time, there are a few basic points investors may not be aware of or tend to forget. The first is that municipal bond insurers provide insurance only for entities that meet their investment grade underwriting standards. In addition, bond insurers have credit underwriters, attorneys and other staff who specialize in public finance, carefully select the municipal bonds they insure and conduct due diligence at origination and surveillance for the life of each bond. This adds value even though the overall safety record of municipal bonds has been historically very strong, and actual missed principal and interest payments remain rare occurrences. Municipal bond insurers just haven’t had to step into the shoes of the issuers they insure very often. In the meantime, new business is written and, revenues are collected, building an insurer’s capital strength to support a book with an expected very low level of losses.

A second point to remember is that municipal bond insurers step in to cover missed principal and interest payments as they come due. Unfortunately, when a particular credit faces severe credit stress, the total exposure of each municipal bond insurer to that credit is quickly added up by some analysts and reporters and bandied about (often with horror and alarm) as if those amounts were due next week or next month. Municipal bond insurers step into the shoes of their insured issuers only as payments need to be made according to the debt service schedule and only to the extent of any shortfall. A financially strong bond insurer keeps bondholders whole while seeking to recover all that it can from the issuer (recovery rates in the municipal bond market generally are higher than in the corporate bond market).

While municipal bankruptcies and defaults remain rare, there have been several well-publicized events (for example, Detroit, Puerto Rico, Jefferson County in Alabama) in the past five years that have highlighted the usefulness of municipal bond insurance. The continued appeal of municipal bond insurance for municipal bond issuers and investors will depend on a number of factors: the ongoing financial strength of the insurers, the credit quality of the insurers’ muni bond book of business, how the insurers perform regarding Puerto Rico, and the spreads between AA rated and BBB/A rated muni bonds. Spreads are constantly changing, of course, and that affects the savings issuers can pocket and the yield investors must forgo when using municipal bond insurance.

The municipal bond market is an incredibly large, diverse, and fragmented place. Municipal bond insurance continues to work hard to make it a safer, more familiar and user-friendly place to invest.

This article was written by Bernard Garruppo and Tom Dalpiaz.

Bernard is a Partner and Managing Director of R. Seelaus & Co., Inc., the corporate parent of Granite Springs Asset Management, LLC, where he previously served as Chief Executive Officer. He has almost 30 years of experience in municipal and other fixed income markets.

Tom is Managing Director, Municipal Bond Investments, Granite Springs Asset Management LLC. Tom Dalpiaz has over 30 years of experience in the municipal bond trading and investment business.

Learn more about Bernard and Tom here.