Higher interest rates and stress in the U.S. municipal market may boost gains for bond insurers, which are positioned to benefit from high levels of muni refundings in the next two years, Standard and Poor's said in a report Tuesday.
The need for protection against municipal defaults may lead to more demand for financial guarantees, even as stress in the legacy bond insurers' public finance exposures puts pressure on the companies, S&P said in its analysis. Continuing high levels of refundings in bond insurers' portfolios may also lead to accelerated growth in capital.
"Capital adequacy among the bond insurers is generally stronger," S&P said in the report. "Bond insurers' business prospects may benefit from high levels of refundings in 2014 and 2015 as the 10-year no-call provisions of some issues are surpassed."
Insured municipal bonds outperformed general obligation debt in July and August, as investors placed more value on guarantees as bond prices fell and default concerns grew. Detroit's bankruptcy filing in July fanned concern over general obligation debt, leading to delays for three Michigan deals that eventually came to market with insurance from Build America Mutual.
"The bankruptcy filing by Detroit may highlight the benefit of and increased demand for bond insurance," S&P said.
While the city's filing for protection did raise concerns over how potential claims and insured credit deterioration could affect bond insurers, they should be able to handle any losses, according to the report.
"Based on our analysis, each bond insurer that has exposure to Detroit has sufficient cushion in its capital adequacy ratio to absorb higher theoretical losses due to increased capital charges or actual losses paid," S&P said.
Any potential claims on Detroit exposures would be made over a period of time large enough to avoid a major loss of liquidity, according to the report. Bond insurers would be able to manage their liquidity needs and benefit from other claims-paying resources from new business production during that time period. S&P said it is monitoring stressed municipalities and that bond insurer risk profiles could be reviewed if their liquidity or capital comes under pressure.
Stress in smaller municipalities may lead to an uptick in bond insurance just as interest rates are climbing, increasing credit spreads, the report said.
"Discussions we have had with market participants indicate the greatest need for insurance is among the smaller, less-liquid issuers," S&P said. "From an investor perspective, retail investors have the greatest need for credit enhancement."
Bond insurers may also benefit from high levels of municipal refundings in 2014 and 2015, S&P said. Treasury yields are lower than they were when the original bonds were issued, indicating that refundings may continue, providing financial guarantors with greater capital positions, according to the report. For transactions in which risk is eliminated due to refundings, bond insurers take unearned premiums into revenue immediately, S&P said.
"The legacy bond insurers are currently experiencing this business dynamic of accelerated growth in capital and rapid run-off of risk exposure," S&P said. "As a result, the capital adequacy positions of these companies are improving."
