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Off Prints
California Debt And Investment Advisory Commission
Phil Angelides, Chair
DEBT LINE
Volume 22, No. 6 June 2003
C
ALIFORNIA
D
EBT AND
I
NVESTMENT
A
DVISORY
C
OMMISSION
T
BOND INSURANCE AS A FORM OF CREDIT ENHANCEMENT IN
CALIFORNIA’S MUNICIPAL BOND MARKET
Frank Moore
CDIAC Policy Research Unit
he purchase of credit enhancement can play an important
role in the municipal debt issuance process. Evidence of this
importance can be found by looking at historical statistics. In
2000, more than half of all California municipal debt was
credit-enhanced, primarily through bond insurance. The
prevalence of bond insurance as a form of credit enhance-
ment points to the need for a resource for municipalities to
use when contemplating the use of this tool. The following
is a summary of a CDIAC report entitled Bond Insurance as
a Form of Credit Enhancement in California’s Municipal
Bond Market. It is intended to provide general concepts for
public issuers, particularly those who are infrequent partici-
pants in the bond market or those who have never used bond
insurance. The full report can be ordered from CDIAC by
phone at (916) 653-3269 or can be downloaded from the
Internet at www.treasurer.ca.gov/cdiac.
Available Types of Credit Enhancement
There are two main types of credit enhancement that are used
most often in municipal bond deals. Bond insurance is
represented by a bond insurance policy that provides a
guarantee of payment of scheduled principal and interest
over the life of the insured bonds should the issuer default.
A letter of credit (LOC) is an irrevocable commitment
typically issued by a commercial bank and will customarily
provide that the trustee or fiscal agent may draw on the letter
when necessary to make payments of principal and/or
interest on bonds. LOCs are typically used for variable rate
bonds and are a declining share of the California credit
enhancement market. The other three types of credit
enhancement, used to a much smaller degree, are lines of
credit, mortgage insurance, and private guarantees. This
article focuses on the primary form of credit enhancement
currently used in the marketplace – bond insurance.
Costs and Benefits of Bond Insurance
Issuers should compare the cost of obtaining insurance to the
benefits derived from using bond insurance. The costs are
usually paid up front but benefits could accumulate over the
life of the bond. Therefore, it is important that the present
value of the savings be greater than the premium charged
(together with the current value of any other costs).
The premium cost of purchasing bond insurance varies
depending on the market conditions for bonds of different
credit quality and the degree of risk perceived by the insurer
in adding the bonds to its portfolio. In most cases, the capital
charges incurred by the insurer in connection with adding a
given transaction to its portfolio also will play a role in the
premium charged. There are also
other costs, such as separate insurance
policies against hazards, earthquakes,
or business interruptions, that must be
maintained over the life of the bonds.
Issuers should also estimate the
benefits derived from using bond
insurance. In determining whether
bond insurance is cost-effective, an
issuer should look at the interest rate
savings or “spread” between an
insured and an uninsured bond. For
example, in 2000, the interest rate
differential between an average AAA-
rated, insured bond and an average A-
rated bond was 8-13 basis points,
depending on maturity. Therefore,
depending on the bond issue amount
and the maturity, it may make sense to
purchase insurance for A-rated bonds.
In addition, issuers also must take into
consideration any new ongoing costs
of compliance with bond insurer
requirements.
As part of a decision to purchase
bond insurance, the issuer must also
consider the marketability of a bond
and its role in reducing the bond yield
demanded by investors. A bond’s
marketability is affected by its
perceived credit risk and liquidity risk.
Bond insurance reduces these two
forms of risk; therefore, the ratings,
and, subsequently, the marketability
of the bonds are improved. In
addition, bond insurance also could
alleviate an investor’s concern about a
Credit and Liquidity
Risk
“Credit risk” is defined as
the potential loss from an
investment as a
consequence of an issuer
defaulting on its debt or
failing to repay principal
and interest to its investors
in full or on time.
Investors in insured bonds
are insulated from credit
risk because they can
depend on the insurer to
make timely payment of
scheduled principal and
interest.
“Liquidity risk” is defined
as the risk that an investor
may not be able to sell a
security in the secondary
market quickly and at
competitive prices. For
example, if an issuer
encounters financial
problems and the rating on
the security is cut, the
market value of these
bonds likely will decline.
Such a decline in market
value could cause
secondary market
liquidity problems
because other investors
may not want to assume
the risk of purchasing such
bonds due to fears of
further decline in value.
Investors in insured bonds
are insulated from
liquidity risk associated
with the issuer’s
circumstances because the
bond’s value relies on the
rating and financial
condition of the insurer.
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particularly complex deal because it provides a commonly
understood means to evaluate the credit quality of complex
financings by transferring the risks associated with these
complexities from the investor to the bond insurer.
The Mechanics of Bond Insurance
Once the decision to consider bond insurance has been made,
the next step is to seek a bond insurance company. Ambac,
FDIC, FSA, and MBIA are the four major AAA-rated
monoline municipal bond insurers in terms of total par value of
obligations insured. Each major firm has different areas of
expertise. In addition to these insurers, specialty insurers
(ACA and AGIC) focus on lower quality, low-rated, or non-
rated debt not considered by the four main companies.
To gain an understanding of the strength of a bond
insurance company, one can look at the credit rating of that
company. For the municipal bond insurance company, a AAA
rating reflects a particular kind of financial strength – the
ability to pay claims. Rating agencies continually evaluate
bond insurers’ claims-paying abilities through detailed analyses
of financial resources, operations, and exposures.
Insurers’ underwriting criteria for evaluating credit quality
differ by bond type and include economic, financial, socio-
political, and structural factors of the issue as well as revenue
and financial history, demographics, and the quality of the
issuing entity as a whole. All AAA-rated firms subscribe to a
“zero loss” or “remote loss” underwriting standard by focusing
on insuring securities with a low risk of default. To further
insulate against loss, insurers typically set conservative limits
on single and aggregate risk and diversify their portfolios by
sector and geographical region.
The actual process of purchasing bond insurance depends
on whether an issue is sold through a negotiated or competitive
sale. Typically, in a competitive sale, the issuer either decides
to buy insurance, makes arrangements to qualify the issue for
insurance and then lets the bidders buy it if they choose, or
requests bids for both insured and non-insured issues. The
investor can also purchase bond insurance once the bonds are
sold and the insurance can be tailored to meet the needs of the
individual investor.
Framework for Decision Making
Local government officials should consider certain factors
when deciding whether to use bond insurance for a financing:
• Decide which type of credit enhancement best suits the
situation. The various types of credit enhancement, including
bond insurance, letters of credit, lines of credit, mortgage
insurance, and private guarantors each have their place.
Although most credit enhancement is bond insurance, there
may be circumstances when another form may be more
efficient.
• Know what insurers consider when evaluating appli-
cants. By knowing some of the insurers’ underwriting criteria,
the issuer can determine if the transaction is viable. For
instance, specialty firms target low investment grade and high
non-investment grade issues. If an issue is in this range, it
might be beneficial to talk to one or more specialty firms. In
addition, keep in mind the insurer’s underwriting criteria
including economic, financial, socio-political, and structural
factors of the issue and the revenue and financial history,
demographics, and the quality of the issuing entity as a whole.
• Approach the bond insurers. An issuer should look at
the specific insurers to decide which best serves its needs. For
instance, an issuer should compare the characteristics of the
transaction with the specialties of the various insurers. An
issuer can approach an insurer that specializes in the appropri-
ate area or approach a firm that is seeking to get into the area,
and might provide a price break. In many cases, an issuer will
benefit from obtaining approval and premium quotes from all
of major monoline insurers if the transaction fits its criteria. In
other cases, an “exclusive” approach may be beneficial,
especially if time is of the essence or the insurer is offering
attractive incentives.
• Do a cost-benefit analysis. Issuers should look at the new
present value cost savings after taking into account all of the
projected costs and savings associated with purchasing bond
insurance. The issuer should evaluate the premium costs and
costs of meeting insurer requirements compared to the pro-
jected interest savings and increased marketability of the bond.
This analysis should be done for the issue as a whole and by
specific maturities. On occasion, it may make financial sense
to insure only specific maturities of an issue.
• Determine the appropriate method of obtaining bond
insurance. Depending on its circumstances, the issuer also
may need to decide on the method of purchase. For instance, if
the bond sale is to be competitive and the potential benefits of
insurance are uncertain, the issuer can rely on a bidder’s option
or multiple bid approach with appropriate bid parameters to
meet its needs. In a negotiated sale, the issuer would decide
whether to insure the issue (or portions of it) in close consulta-
tion with its underwriters near the time of the pricing. Alterna-
tively, the purchase of bond insurance can be left up to the
individual investors in the secondary market.
This Offprint was previously published in DEBT LINE, a monthly publication of the California Debt and Investment Advisory Commission (CDIAC). CDIAC was
created in 1981 to provide information, education, and technical assistance on public debt and investment to state and local public officials and public finance
officers. DEBT LINE serves as a vehicle to reach CDIAC’s constituents, providing news and information pertaining to the California municipal finance market.
In addition to topical articles, DEBT LINE contains a listing of the proposed and final sales of public debt provided to CDIAC pursuant to Section 8855(g) of the
California Government Code. Questions concerning the Commission should be directed to CDIAC at (916) 653-3269 or, by e-mail, at [email protected].
For a full listing of CDIAC publications, please visit our website at http://www.treasurer.ca.gov/cdiac.
All rights reserved. No part of this document may be reproduced without written credit given to CDIAC. Permission to reprint with written credit given to
CDIAC is hereby granted.
