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Fixed-Income Insights

The industry is far smaller than it was 10 years ago. What role does it play in the current market?

[Note: This article is from the October 2017 edition of The Muni Quarterly.]

Before the financial crisis of 2008–09, bond insurers were a major factor in the municipal-bond market. At the peak of activity in the bond insurance industry, there were seven ‘AAA’ rated bond insurers, and approximately 60% of all new-issue municipal bonds were insured. But in the wake of the meltdown of the subprime mortgage sector that precipitated the crisis, many observers predicted the demise of the bond insurance industry.

Nearly a decade later, however, the industry is still around, albeit in a much smaller form. Currently, only about 6% of the municipal new-issue market comes with bond insurance, and there are only two active bond insurers: Assured Guaranty Ltd. (Assured) and Build America Mutual (BAM).

The primary function of municipal bond insurance is to provide investors with an additional layer of protection against loss. So, if there is an event of default by an issuer, the insurer supports the debt-service payment for the life of the bonds. In addition, bond insurance often enhances liquidity and provides price stability if the underlying credit quality of the bond deteriorates.  When insured bonds are marketed, they are assigned the insurer’s bond rating. In exchange for the added security, the investor accepts a lower return as a result of the higher rating.

Before the onset of the financial crisis, the majority of insurers carried ‘AAA’ ratings, allowing most muni-bond issuers to obtain the benefit of a higher rating by using insurance. An issuer could choose to have its bonds covered when the cost savings derived from issuing bonds at the insurer’s rating level exceeded the cost of the insurance premium.

Boom and Bust
The first policy was written in 1971 when AMBAC insured bonds issued by the Greater Juneau Alaska Borough. The bond insurance business received a boost from two high-profile events: New York City’s brush with bankruptcy in 1975, and the default on the bonds of Washington Public Power Supply System in 1983.  Growth continued as the municipal bond market transformed, from an industry in which banks were major participants to one that became dominated by individual investors who were less inclined, or less able, to perform their own credit analysis.  By 2005, the proportion of new municipal issuance (on a par-value basis) covered by insurance reached a peak of 57%.

The low frequency of municipal-bond defaults made the bond insurance business seem safe. However, insurers began to increase their leverage, insuring bonds using less capital. They also diversified into the more lucrative business of insuring structured debt instruments. The fact that many of these securities were backed by subprime mortgages led to sizable claims on the insurers’ modest layers of capital when the crisis began to hit in 2007, resulting in the insurers becoming insolvent or suffering multiple-notch downgrades from credit rating agencies.

At its low in 2012, the percentage of newly issued muni bonds covered by insurance was only 3%.  Since then, the issuance of insured bonds gradually has picked up, and now represents approximately 6% of all issuance. It is important to reiterate that municipal bonds had no role in the collapse of the bond insurers.

Post-Crisis Landscape
As the only insurer to survive the financial crisis relatively unscathed, Assured “owned” the new business insurance market from 2009 until BAM came along in late 2012.  Assured operates through two primary subsidiaries: Assured Guaranty Municipal Corp. (AGM) and Assured Guaranty Corp. (AGC). Both are rated ‘AA’ by Standard & Poor’s (S&P), while Moody’s rates AGM ‘A2’ and AGC ‘A3.’

 

Bond Insurance: Where the Major Players Stand

Source: Company filings. Data as of June 30, 2017. Claims-Paying Resources (CPR) consist primarily of statutory capital (policyholders' surplus and contingency reserve) and unearned premium reserves. References to these specific securities and issuers are for illustrative purposes only, and are not intended, and should not be interpreted as, recommendations to purchase or sell such securities or assume that investments in the securities were or will be profitable.
*Bond insurance operations of MBIA Corp.

**Currently operating under a rehabilitation plan with the Superintendent of Financial Services of the State of New York.

 

BAM, with its public finance-only focus and unique mutual business model, was able to capture business immediately, attaining a 38% share of the bond insurance market by 2013. A key advantage for BAM is a lack of legacy problems. Bonds from troubled issuers Harrisburg (PA), Stockton (CA), Detroit, and Puerto Rico are all missing from BAM’s list of exposures.  However, a disadvantage of being a startup is size, with BAM’s claims paying resources of $643 million dwarfed by Assured ($12.2 billion) and National Public Finance Guarantee Corp. ($4.6 billion).

The latter firm represents the remaining operations of another major pre-crisis player in the industry. In 2009, MBIA Corp. reorganized itself so that its municipal insurance business, National, was effectively walled off from the structured finance business. In early 2014, National was upgraded, to ‘AA-’ from ‘A’ by S&P and to ‘A3’ from ‘Baa1’ by Moody’s, but then was downgraded, to ‘A’ by S&P in June 2017. These ratings were never sufficient to support National’s effort to reengage with the new-issue market; and in July 2017, the company formally announced that it was no longer seeking new-issue underwriting.

Besides the two active bond insurers and National, there are several other insurers that are now in run-off mode, writing no new business, but managing remaining exposures.  Ambac, which was formerly rated ‘AAA,’ filed for bankruptcy in 2010, and then reemerged in 2012. Under supervision of the Wisconsin Insurance Commissioner, Ambac is undergoing rehabilitation (the insurance version of restructuring/bankruptcy), which included the establishment of a segregated account into which the more problematic exposures were placed. Ambac has paid most claims, including those on Puerto Rico bonds. Although Ambac has $8.8 billion in claims-paying resources, it has significant deferred claims, so there is no assurance that these resources will be available in the future to pay claims.

FGIC is another insurer that had been rated ‘AAA,’ but it was downgraded to below investment grade. In September 2008, most of FGIC’s public finance insured par outstanding was reinsured by MBIA. In 2012, FGIC was placed into rehabilitation by the New York State Superintendent of Insurance, and a plan was approved with an initial cash payment on claims of 17%, which has been increased most recently to 25%, which is the percentage FGIC paid on Puerto Rico claims. The plan became effective in August 2013.

Current Challenges
The current environment has been challenging for the bond insurers. Low interest rates constrain returns on the insurers’ investment portfolios, weighing on profitability. The majority of the insurers’ investment portfolios consist of fixed-rate securities. The bigger challenge has been credit-spread compression, which often accompanies low interest rates, as investors are willing to accept increasingly more risk (which means less bond insurance) in order to attain higher incremental yield. If and when interest rates rise, the bond insurance industry should, we believe, see an increase in volumes and profitability.

Puerto Rico’s fiscal crisis has had an impact on insurers. Of the surviving insurers, only BAM can claim no exposure to Puerto Rico. Assured’s exposure to Puerto Rico bonds is $5.5 billion gross par amount, and National’s is $4.3 billion. Although these numbers are sizable, the exposure becomes a bit more palatable if one were to consider that bond insurance guarantees timely payment of principal and interest only when due. For example, in 2017, debt service on Puerto Rico bonds is $464 million for Assured and $333 million for National. The credit rating agencies have reported that even assuming severe haircuts on Puerto Rico debt, Assured and National should have sufficient resources to cover their insured exposures.

Although it plays a less prominent role in the market, bond insurance still serves an important function for many municipal investors. The insurers have and continue to cover payments from the few defaults that have occurred over the past several years. The value of insurance is evidenced by the fact that Puerto Rico bonds insured by Assured and National are trading close to and above par, while the uninsured bonds are priced well below 50. We expect the industry to survive, and although bond insurance can provide additional security for the bonds that we purchase, the credit quality of the underlying issuer will be our primary consideration. That is why our analytical team’s credit research is a critical input in our investment decisions.

 

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THE MUNI QUARTERLY

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The October 2017 edition offers insights from our analysts on key topics for municipal bond investors, along with essential market information.

July 2017 edition
April 2017 edition

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