Written by: Eric Snyder ; Maria Rahni, CFA
Role of Insurance
Municipal bond insurance is a guarantee from a monoline insurance company that the holder of a muni bond will receive scheduled interest and principal payments when due, even in the event of a default by its issuer. Municipal bond insurance is often described as a credit enhancement as it enables a municipality to effectively borrow the credit rating of the insurer, which is typically higher than its own on the rating scale. This credit enhancement can help to reduce the borrowing costs of the issuer.The history of municipal bond insurance can be traced back to 1971 with the founding of Ambac, the industry’s first monoline insurer. The industry gained traction in the mid-1980s after the Washington Public Power Supply System defaulted on $2.25 billion in revenue bonds and by 2005, insured bonds made up 57% of total municipal bond issuance and were guaranteed by nine firms, seven of which carried AAA ratings. Meanwhile, in the early to mid-2000s, the insurers diversified their businesses by insuring structured debt settlements that were backed by risky subprime mortgages.When the subprime mortgage crisis took hold in 2007-2008 and severely impacted the structured debt market, most of the monoline insurers either fell into bankruptcy and folded or lost their AAA ratings. Today, Assured Guaranty and Build America Mutual are the only two firms writing new business and they were most recently rated AA. The market share of new municipal issues carrying insurance dropped steeply and has hovered around 5-6% since 2014.
Why Invest in Insured Munis?
Why would someone want to invest in insured municipal bonds? The most obvious reason is the reduction in credit risk: if an issuer goes bankrupt, holders of an insured bond from the issuer are still guaranteed their principal and interest, which should help mitigate market depreciation of affected bonds. While muni defaults are rare, this extra protection could provide better price stability, greater market liquidity and improved investor outcomes over time. Moreover, the incremental price of owning an insured bond over its uninsured counterpart is relatively low – investors give up only a trivial amount of yield, just 10-15 bps, when they choose a bond with credit enhancement.Historically speaking, investors would have been better off by carving out a piece of their investment grade muni portfolio for insured bonds. As displayed in Figure 1, the insured municipal market, as represented by the Bloomberg Barclays Insured Municipal Bond Index, has outperformed with less downside capture compared to the broad muni market over the last 5 years, as represented by the Bloomberg Barclays U.S. Municipal Bond Index. Additionally, Figure 2 shows that insured munis have seen better risk-adjusted returns vs. the broad muni market over multiple time periods.
Figure 1 – Insured muni bonds have seen 5-year cumulative returns of 22.5% (4.15% annualized) vs. the broader market at 19.1% (3.56% annualized)
Source: Morningstar, 4/30/2014 – 4/30/2019.
Figure 2 – Insured municipal bonds have seen higher returns and typically less risk than the broader muni market, leading to higher Sharpe ratios (risk-adjusted returns) over time
Source: Morningstar as 4/30/2019.
How to Implement into Your Muni Portfolio
How much of your portfolio should you allocate to insured muni bonds? Like any other allocation decision, this is dependent on a number of factors including a client’s risk tolerance, income needs and market views. Investors concerned about credit risk may want greater exposure to insured munis, but less conservative investors can also benefit from investing in this part of the muni market and subsequently diversifying their portfolios.Below is an example of a muni bond portfolio investing in both the investment grade and high yield segments of the market, with return and risk statistics before and after adding an insured muni sleeve. As shown below, replacing 20% of the portfolio with insured munis increased return and reduced risk, all while keeping the allocation to high yield and investment grade intact.
Figure 3 – Hypothetical portfolio example: replacing part of an investor’s investment grade muni allocation could result in better risk-adjusted returns
Source: Morningstar, 4/30/2014 – 4/30/2019.
Today’s muni market is reminiscent of the 1980s given recent credit events, specifically, the high-profile defaults in Detroit and Puerto Rico. These examples illustrate the value of insurance, which became apparent when insurers stepped in to pay claims following Puerto Rico’s default. With investor confidence renewed, we believe demand will rise for insured municipal bonds and that the market has room to grow. Thus, we believe that insured municipal bonds still have the potential to add value within investor’s portfolios
.That said, investors should keep in mind that some monoline insurers are better positioned than others to step in and pay default claims. This essentially adds an additional layer of analysis when selecting individual bonds. Therefore, relying on an experienced manager that is capable of stress-testing the insurers is prudent within this segment of the muni market.