Bond insurers got a lift as an industry outlook report and rating upgrades by Standard & Poor's on Assured Guaranty and National Public Finance Guarantee bolstered Wall Street's confidence in the business.
S&P bumped Assured's rating to AA from AA-minus, and MBIA's National to AA-minus from A late Tuesday. Credit-
default swap spreads on the two firms plunged the most in as much as six months, indicating investor confidence in insurers.
"We think market penetration should increase in 2014 to 7% or 8%," David Veno and Marc Cohen, Standard & Poor's analysts, said in an interview. "Competition is needed in the market and the issuers have highlighted that three bond insurers would be well-received."
Traders participating in the credit-default swap market seemed to agree, with spreads on Assured Guaranty Municipal Corp. swaps with five-year tenor falling by 11.4% to 299 basis points Tuesday, the biggest drop since at least September, according to data from S&P Capital IQ. MBIA Inc. spreads in the same tenor fell 10.8%, the second biggest drop since September.
Credit default swaps are a form of insurance in which the purchaser makes a fixed payment in exchange for compensation by the seller in the event that the underlying issuer defaults or has a related credit impairment. A lower spread means the buyer pays less for protection.
The volume of transactions on Assured swaps reached a four-year high last week, according to Donald van Deventer, chief executive officer and founder of Honolulu-based Kamakura Corp.
"Opinions on the quality of the credit certainly improved," van Deventer said in an interview. "Because there's so much volume behind this, the basis-point drop is a significant move."
There were 218 contracts on MBIA swaps traded in the week ended March 14, more than any other corporate swap according to data from Depository Trust and Clearing Corp. Assured's contracts were traded 154 times, with more than $2.01 billion in notional principal traded.
"It may be a mistake to attribute the change to the rating agency opinion," van Deventer said. "There are a lot of Wall Street people that are very smart, and it may not be the ratings change that necessarily caused the move."
S&P's rating change means Assured will now boast the same rating as the only other currently active financial guarantor in the municipal market, Build America Mutual. BAM has had an AA rating from S&P since before it began underwriting business.
"We are pleased that S&P has recognized the strength of our competitive position and market acceptance along with our extremely strong capital base and our pricing discipline," Dominic Frederico, president and chief executive officer of Assured, said in a press release Tuesday.
Assured's structured finance portfolio no longer carries a disadvantage associated with issuer and investor sentiment, S&P said in the report, and the insurer's timely payments in the event of high-profile defaults last year has lent its business credibility.
"This is another positive sign of the resurgence of the municipal bond insurance industry," Mike Stanton, head of Strategy and Communications at BAM, said in an email. "The market now has a choice between three guarantors in S&P's double-A category, and will weigh the benefits of our unique mutual structure versus a public-company model."
The simultaneous upgrade of National's parent company MBIA Inc. to A-minus from BBB will allow the firm to reduce holding company leverage over time, MBIA chief executive officer Jay Brown said in a press release.
"We're pleased that S&P has recognized the positive steps we've taken to reduce risk and volatility throughout the organization as well as National's strong financial profile and competitive prospects," Brown said. "With a rating in the double-A range now in hand, National will turn its attention toward executing its business plan and supporting the credit enhancement needs of municipalities."
S&P's upgrade of National to AA-minus puts the insurer in the position to do business after a six-year hiatus dating back to the financial crisis, Mark Palmer, an equity analyst at BTIG Research, said in a report.
"Insofar as a bond insurer's credit rating is its currency, the industry as a whole became stronger yesterday," Palmer said in an email. "With three bond insurers rated in the 'AA' ballpark, bond insurance as a product now has additional validation."
Bond insurance's reach will depend on the pace at which interest rates rise. In addition to primary issuance, bond insurers should continue to take part in secondary market transactions, allowing holders of existing bonds to pick up insurance, the S&P analysts said.
"That's been a very profitable business for BAM and Assured," S&P's Cohen said. "These high-profile bankruptcies that have occurred make investors want to go and insure their existing investment in secondary market transactions."
Market penetration by bond insurers was in free-fall leading up to 2013 after a precipitous drop in business following the financial crisis. The onset of the recession in 2008 left the industry responsible for just 19% of new bonds, and the amount of insured bonds has fallen yearly before an uptick in 2013 that left penetration at 3.6%.
Assured claimed 61% of the market in 2013 with $7.38 billion of insured bonds by par amount, while BAM insured $4.44 billion. Berkshire Hathaway Assurance had a single deal in 2013 that accounted for less than one percent of the market.
In November, S&P issued a report warning that insurers were getting less compensation for risk as compressed credit spreads and competition forced the Assured and BAM to cut their prices.
With credit spreads expected to widen and interest rates set to rise, Cohen and Veno said the rating agency will be watching how competitive pricing takes shape in the coming year.
"We expect interest rates to rise and credit spreads to widen which will allow the bond insurers to charge more for their product," Veno said. "It won't wipe out competitive pricing completely but it will give some flexibility."
