In the April 21 issue of The Bond Buyer, guest commentator Richard Ciccarone of McDonnell Investment Management reminded us of what can happen when municipal bond ratings fail to reflect the very real risks of economic downturn. In 1935, as many as 3,252 issues were in default, and 78% of them had been rated double-A or better in 1929.
Neither Mr. Ciccarone nor most others would suggest that we are entering into a period comparable to the Great Depression. Nonetheless, a series of unprecedented dislocations in the global credit markets has led investors to carefully revisit types of risk that may have seemed insignificant less than a year ago - municipal credit risk among them.
It is not necessary to go back to the Depression era to find data on municipal defaults - the reality of even our modern financial system is that muni bonds do default. The growth of the bond insurance industry in recent decades was directly related to defaults or near defaults by a number of municipal issuers, including the Washington Public Power Supply System, Philadelphia, New York City, the Allegheny, Pa., Health Education and Research Foundation, and Orange County, Calif. Since 1990, a total of $34 billion of tax exempt bonds have defaulted. Certainly there were recoveries - and in some cases, bondholders were repaid in full - but the fact remains that there were more than 2000 municipal bond issues that defaulted during that time period.
Data sources on municipal defaults generally underreport actual experience for a variety of reasons. Certain rating agency data, for example, includes only bonds rated by that rating agency. For many data sources, defaulted credit-enhanced bonds - whether insured or with letters of credit - are excluded from the default totals so long as the credit enhancer makes the debt service payment.
A draw on a bond insurance policy means the issuer is in default from the perspective of the bond insurer. However, so long as the insurer pays bondholders, the data source may not view this draw on the insurance policy as a default. Both the issuer and the insurer must fail to make payments in order to categorize this event as default. Thus, given the fact that to date no bond insurer has ever failed to pay an insured claim, it is clear that commonly available municipal bond default rate data understates the true extent to which issuers experience financial distress.
The global credit crisis has directly impacted both municipal issuers and bond insurers, and unprecedented rating actions have changed the bond insurance landscape. Despite this turmoil, market data tells us that bond insurance continues to offer value for municipal debt buyers, sellers, and issuers. While penetration rates have dropped, they are far from zero, and several firms are very actively writing new business. In addition to their traditional business of insuring new bond issues, those insurers that have retained their stable triple-A ratings have been active in assisting municipalities in converting auction-rate bonds to insured fixed-rate bonds or variable-rate demand notes.
Investors' continued demand for bond insurance is evident in wider spreads for insured triple-A versus uninsured bonds. The spread between a natural triple-A municipal bond and an insured triple-A municipal bond has widened to 17 from 12 basis points over the past 12 months. The relative value of insured bonds versus natural triple-A bonds has fallen by 5 basis points. The spread between an insured triple-A bond and an uninsured triple-B bond, however, has widened by 61 basis points during that same period. This shows that the value of bond insurance to investors has increased by 56 basis points.
Investors are not only continuing to purchase bond insurance in the face of this market turmoil, they are valuing it more highly, as evidenced by the price they are willing to pay. While the global credit crisis has shaken the capital markets, it has also underscored the importance of managing risk, including municipal credit risk.
In addition to protecting investors, bond insurance remains attractive to issuers for liquidity and access to markets. There are many small municipal issuers (more than 10,000 muni bonds are issued annually) for which bond insurance provides a vital means of access to the capital markets. From 2000 to the present, the average size of an insured municipal bond issue was $33.2 million. Notwithstanding credit quality, such small issues may not contain sufficient liquidity to enjoy a low cost of capital. Bond insurance, however, offers a more homogenous product to investors that benefits smaller issuers via efficient access to the capital markets.
Financial guarantors also actively seek to remediate problematic situations in order to avoid defaults. Insured bonds are subject to extensive portfolio surveillance procedures by the bond insurance companies. While each firm has a slightly different process, all are concerned with identifying potential problems early and being proactive in resolving issues before they result in a draw on the insurance policy.
For some sectors, such as health care, outside consultants may be called in to assist in these efforts. We saw such efforts following Hurricane Katrina. Bond insurers worked together with issuers and state officials following the August 2005 storm to assess the damage and offer solutions. An insured refinancing and restructuring of the Louisiana Stadium and Exposition District bonds, for example, including some additional security, helped the district's bonds avert default and provided time for the area's tourism, convention activity, and hotel occupancy to recover.
At the end of the day, investors determine the value and role of bond insurance in the marketplace. Unlike other insurance products such as auto insurance, no one needs to buy bond insurance. Issuers use credit enhancement when it provides them with cost savings in accessing the capital markets. Investors choose insured bonds to the extent that they see value in the product - and the measure of that value can be seen in the market every day as insured and uninsured bonds are priced. As we look at the market today, even in its tattered condition, we observe that investors continue to speak with their wallets.
Michael Schozer is president of Assured Guaranty Corp.
