As Detroit’s bankruptcy battles unfold, an important ally of muni investors is emerging: bond insurers.
Yes, the companies that unwisely strayed from their bread-and-butter business and were pilloried during the financial crisis are now stepping up and ensuring Detroit bondholders receive full payment.
It seems a far cry from the days of 2007 and 2008, when some financial gurus told investors bond insurance was unnecessary and buying insured municipal bonds was a waste.
Of course, those were the days when insurers lost their top ratings after forays into the mortgage-backed security resulted in significant losses. Their activities were, correctly, deemed reckless and inexcusable, but the conclusions drawn by some – that insurance was worthless – were clearly off the mark.
Merits of bond insurance
As we pointed out back then(“When Bond Insurance Does Matter“), municipal bonds rarely default; despite recent high-profile bankruptcies, it’s still an extremely rare occurrence. Bond insurance has seldom been necessary to ensure timely payment of principal and interest. In fact, the overwhelming majority of munis are extremely secure on their own.
However, the merits of bond insurance can’t be denied, as the market – and recent events – will attest.
Insured munis are beating the overall muni market for the first time since 2007, before insurers lost their top credit grades, according to Bloomberg. The gap between yields on uninsured 30-year “AAA”-rated debt vs. similar insured debt is at its narrowest in more than two years.
According to Reuters, more than 85% of Detroit’s debt is insured by six companies, though most of the losses are expected on only about $530 million of unsecured general obligation bonds, payable over the next 22 years.
“If there were never any losses, no one would buy insurance,” legendary investor Wilbur Ross told Bloomberg. As of June, Ross controlled about 8.1% of Assured Guaranty shares. “The performance of insured munis clearly demonstrates the value.”
Insurers will likely play a key role in fighting the highly controversial plans by Detroit’s emergency manager to treat holders of unlimited general obligation bonds the same as owners of “limited” bonds. Unlike GOs, limited bonds do not require voter approval and are paid out of general funds. A report by Barclays Plc suggests that as the case winds its way through the bankruptcy process, there is a “strong case” to be made to treat the GO debt as secured, which could make investors whole.
Insurance seen as win/win
Traditionally, bond insurance has been seen as one of the few financial innovations that benefits everyone. Issuers gain from the quality enhancement by borrowing at a lower interest cost, while investors enjoy the peace of mind provided by the additional layer of security.
Still, the financial crisis prompted many to question the wisdom of insurance, as the number of new issues with insurance shrunk from approximately 50% to about 3% this year.
When determining the merits of an investment, it’s important for investors to understand the underlying strength of an issue. However, as a very few but high-profile examples have shown, bond insurance can provide an important added layer of protection and peace of mind.
