The global financial crisis of 2008 caused a sea change in the use of bond insurance in the municipal market, and market observers offer vastly differing opinions about its value and the role it will play in public finance in the future. But what do active participants in the municipal market really think about bond insurance?
To gain a clearer view, Assured Guaranty commissioned a survey by SourceMedia, publisher of the Bond Buyer, to ask that question of institutional and retail asset managers and sales, trading and underwriting professionals.
The survey obtained responses from 334 individuals. Of the institutional and retail asset management respondents, 92% are considered municipal investment decision-makers because they either recommend or make final decisions about investments. The other asset management respondents review credits and approve investments. Institutional sales, trading and underwriting professionals constituted 39% of the sample.
Insured Bonds Are Widely Held and Traded
In its most important finding, the survey confirmed the market’s continuing appetite for insured municipal bonds. Seventy-five percent of respondents purchased insured bonds in the 12 months preceding their interviews for the survey, which was concluded in September of this year. Ninety percent of institutional asset managers did so.
Institutional asset managers cited default protection, improved market liquidity, the value-added service a guarantor provides through credit underwriting and surveillance, and improved trading value as the most valuable potential benefits of bond insurance to their firms.
Significantly, when ranking the relative value of such benefits, 31% of institutional asset managers and 39% of sales, trading and underwriting professionals ranked trading value either first or second. That finding is consistent with Assured Guaranty’s recent experience, where it is increasingly being asked to insure substantial portions of uninsured bonds in the secondary market.
Potential Increases in Demand
The survey results signal that both institutional and retail demand for bond insurance are likely to increase, given recent market developments. For example, 85% percent of respondents believe additional demand for insurance would result from an increase in default risk among municipal issuers. Therefore, a heightened perception of municipal risk will drive greater insurance demand.
While municipal risk remains lower than that of almost any other investment category, a small number of high-profile defaults, as well as statements from public officials that they are considering bankruptcy, have been in the public eye. Also, after explicitly or implicitly recalibrating municipal ratings upward a few years ago, rating agencies have more recently noted what S&P called a “weakening trend” in public finance ratings. While this increase in downgrades of rated securities is not likely to mean materially increased defaults, and certainly not in the universe of bonds Assured Guaranty insures, it does contribute to a less confident market atmosphere in which bond insurance should have greater appeal.
Importance of a Track Record
Given these developments, it is not surprising that 80% of respondents deemed bond insurers’ track record of making payments on defaulted municipal bonds a significant factor in the potential growth of demand for insured bonds. It is reasonable to believe that if an insurer maintains a strong capital position while it keeps investors whole through difficult distress scenarios — as Assured Guaranty has done in Jefferson County, Alabama, Harrisburg, Pennsylvania and Stockton, California — it will be a preferred insurance provider for investors focused on default protection. The bottom line is that municipal bond insurance works as intended, and investors are seeing it in action.
The results also provide evidence that rating uncertainty suppresses demand for bond insurance. Forty-eight percent of respondents ranked ratings volatility of the insurer as their first or second highest concern about purchasing insured bonds, and 79% percent of respondents believe that stable bond insurer ratings could be a significant factor in driving additional demand. This is logical, as the possibility of imminent downgrade deters both issuers and investors. At best, the risk is factored into the pricing, reducing the savings the insurance can provide to issuers.
A company like Assured Guaranty may therefore see improvement in production once all its ratings are stable. After all, Assured Guaranty has endured rating uncertainty for roughly two-thirds of the last three years as Standard & Poor’s resolved its new bond insurer rating criteria and Moody’s Investors Service held the company under review for a prolonged period. This only reinforces the fact that market share should not be an important criterion in evaluating a guarantor’s financial strength.
Sensitivity to Yields and Credit Spreads
However, even when the insurer has stable ratings, its growth in production will depend on wider credit spreads and higher interest rates. Seventy-five percent of respondents believe increased credit spreads will be a significant factor driving additional bond insurance demand, and 70% ranked increased municipal yields as significant. These views make sense. As spreads widen and yields increase, bond insurance will offer greater savings to issuers, and investors will be less inclined to sacrifice safety for yield. This bodes well for future market growth, as today’s tight credit spreads can be expected to return to historically typical levels in time, and interest rates cannot remain at all-time lows indefinitely.
To be sure, the economic recovery has been slower than expected, and interest rates may not rise very soon. But a well-established bond insurer is under no short-term pressure to chase market share under less than favorable conditions, which could potentially weaken its risk profile and long-term profitability. This is because a well-established insurer has a highly predictable stream of future earned revenue from premiums it has collected but not yet earned. Assured Guaranty, for example, currently has a $5.6 billion unearned premium reserve. These deferred revenues will be earned over the life of the insured portfolio.
Moreover, even with demand suppressed by low yields, tight spreads and rating uncertainty, Assured Guaranty has continued to generate a substantial amount of profitable business without compromising credit quality standards or pricing. The survey results give every reason to believe that, as we move into the next phase of the business cycle, we will see increasingly robust demand for bond insurance.
William Hogan and William O’Keefe are Senior Managing Directors in the public finance department at Assured Guaranty.
Data in the commentary was derived from a survey conducted by the SourceMedia Research Group, which was commissioned by Assured Guaranty to assess investor attitudes about bond insurance in the municipal market. SourceMedia, parent company of The Bond Buyer, conducts its research under the professional ethics standards set out by the Council of American Survey Research Organizations, and all respondents’ identities were kept strictly confidential. Among completed surveys, 61% were from the buy side (institutional and retail asset managers), 39% from the sell-side (sales, trading, and underwriting professionals) while 54% of the responses came from the institutional markets and 46% from retail. The sample size is sufficient to draw conclusions about the overall universe within a margin of error of approximately 5%.
