For Bond Buyers, Is Insurance Worth It?

The huge wave of municipal bond issuance in California and the recent slide in the state’s credit rating have created either a problem or an opportunity, depending on one’s perspective.

For the state, the problem is finding enough private bond insurance coverage to satisfy nervous investors.

For bond insurance companies, especially newcomers to the California market, it’s an all-you-can-eat buffet with more than enough business for those with the capital and the willingness to shoulder the risks.

For investors, meanwhile, there’s the question of whether the amount of yield sacrificed on privately insured tax-free bonds, compared with uninsured issues, is worth the peace of mind that insurance provides.

The yield “spread” between insured and uninsured California general obligation bonds widened to as much as 0.65 percentage point on long-term issues earlier this summer as the Legislature appeared deadlocked over a budget deal.

The spread has eased to below half a percentage point since the budget was approved in late July. But that is still high by historical standards.

An uninsured long-term state muni bond might yield about 5.5% a year tax free, for example, while an insured issue might yield closer to 5%.

Default rates on municipal bonds in recent decades have been minuscule, and mostly limited to bonds from very small issuers. Yet insured bonds have grown steadily in popularity.

Nationwide, just less than 50% of all muni bonds issued last year were insured. That share was under 20% in the mid-1980s, according to the California Municipal Bond Advisor, a newsletter in Palm Springs.

The muni-bond insurance business, like the accounting industry, is dominated by a Big Four, all AAA rated by the major credit-rating firms and all New York-based: MBIA Insurance Corp., Ambac Assurance Corp., Financial Guaranty Insurance Co. and Financial Security Assurance Inc.

In return for fees paid by bond issuers, the insurers essentially lend their own credit ratings to the bonds they insure, setting aside a certain amount of capital to back up their guarantee that interest payments will be made on time if the issuer should default. The lower the issuer’s rating, the greater the amount of capital required to back the bonds.

The insurers also must maintain geographic diversity in their insurance coverage, to guard against a catastrophe in one part of the nation triggering a rash of of defaults.

Given those constraints, and the increasing popularity of insured bonds, the Big Four have little capacity to insure new California general obligation bonds.

“We’re pretty much tapped out on California general obligations,” said Sheila Flanagan, managing director of FSA’s West Coast office in San Francisco.

That’s good news for firms such as AAA-rated XL Capital Assurance Inc., which came into the California market in 2001 and already has written more than $1 billion of insurance.

And the slippage in California’s credit quality has created new opportunity for second-tier insurers such as AA-rated Radian Asset Assurance Inc., which couldn’t have done business with California when the state’s general obligation debt ratings were higher.

“Now we’re able for the first time to offer value,” said John DeLuca, Radian’s vice president for market development.

During the budget crisis this summer, Standard & Poor’s dropped the state’s rating to BBB, a couple of notches above junk-bond status. Moody’s Investors Service, the other top ratings firm, held off until the budget deal was done, then cut its rating on California by one notch, to A3 from A2.

Radian’s AA rating could save the state about a quarter percentage point in interest if it were to insure new bonds, based on current market prices for California debt, DeLuca said.

With demand for insured bonds at high levels, the industry’s capacity constraints are frustrating to state officials.

Juan Fernandez, director of public finance in the office of State Treasurer Phil Angelides, said the state was able to obtain insurance for only $128 million worth of the $1.7 billion in general obligation debt it issued in June. Similarly, only $202 million worth of the $2 billion in general obligation bonds issued in April were insured.

“If the capacity were available at a reasonable price, I would have insured the entire amount,” Fernandez said.

Given the state’s plans to continue issuing bonds in record amounts -- an additional $2.5 billion in general obligation bonds is scheduled for this fall -- “I don’t have the expectation that [more capacity] will be available any time soon,” Fernandez said.

For investors, the issue is whether insured state bonds are worth it, considering the yield that is sacrificed relative to uninsured issues.

Private insurance does provide an iron-clad guarantee of principal and interest payment. And insured bonds can be easier to sell in the marketplace.

But considering the slim risk that California would default, some analysts say they’d rather buy uninsured bonds, earn higher yields and take their chances.

“If anything, now would be a good time to sell some insured California munis to buy the uninsured bonds,” Zane B. Mann, publisher of the California Municipal Bond Advisor, wrote in his most recent edition.

“No matter how bad things get, California is not going to default,” said Marilyn Cohen of Envision Capital Management in Los Angeles.

Experts say it’s possible insurance firms could decline to insure new state bonds, if California’s credit ratings are cut again.

“The insurers are going to be very sensitive to obligations that get chopped to non-investment grade,” said Tom Abruzzo, managing director at ratings firm Fitch Inc. in New York.

The amount of California bond issuance and the sliding ratings aren’t the only factors affecting insurance capacity.

Some of the big insurers feel they have more profitable places to put their money, according to Alex Orloff, bond-insurance analyst at Banc of America Securities in New York.

In Europe, for example, only about 2% of municipal bonds are insured, Orloff said. There is far more growth potential there than in the United States, where it will be difficult to improve on the industry’s 50% penetration, he added.