Course 210: Municipal Bond Insurance
Drawbacks of Insuring Municipal Bonds
In this course
1 Introduction
2 Why Insure Municipal Bonds?

A municipal bond is an obligation of debt issued by states and city and local governments to raise money for the public funding of projects and services such as schools and housing. Municipal bond insurance is an insurance policy on the bond and is underwritten by a private insurance company.

Insurance provides investors with the security that no matter what happens to the finances of the government that issues the bond, the bond's interest and principal payments will be made.

Like other bonds, municipal bonds have certain risks associated with them. A bond's primary risk is that it could default. If a bond defaults, it means the government that issued the bond does not have the funds to make timely payments of interest and principal.

Municipal bonds also count on the projects they finance to bring in expected revenues. The governments that issue municipal bonds often rely on these revenues to pay back the bonds they issue. Municipal bonds therefore also run the risk that these projects will fail to produce the revenue needed to pay off the bonds. Insurance provides investors with the security that no matter what happens to the finances of the government that issues the bond, the bond's interest and principal payments will be made.

Bonds with low default risk are given high credit ratings, which influence the market prices of the bonds. A bond that is insured will have a higher credit rating than a non-insured bond. Insured bonds receive the highest credit rating possible: AAA. The higher credit rating enables the bond issuer to pay a lower interest rate on the bonds when they are sold. There are four major agencies that provide bond credit ratings. These agencies are the following:

  • Moody's Investors Service
  • Standard & Poor's Corporation
  • Fitch IBCA, Inc. 
  • Duff & Phelps Credit Rating Co.

Insuring a municipal bond also increases the bond's marketability. The insurance helps smaller issuers who are unknown or do not issue bonds frequently to be taken seriously by investors.

[subsection What Does Municipal Bond Insurance Cover?

3 What Does Municipal Bond Insurance Cover?
4 How Municipal Bonds Are Insured?
5 Drawbacks of Insuring Municipal Bonds
6 Municipal Bond Insurers
7 Should You Buy Insurance?

Municipal bond issuers must pay an insurance premium to obtain insurance coverage for their bonds. Although investors do not pay these premiums directly, the fact that issuers and investment firms pay them means that these costs get transferred to investors. These costs are passed on in the form of lower interest rates on insured bonds. Issuers reduce their borrowing costs because insured bonds are rated AAA. Bonds rated AAA generally yield lower interest rates than lower-rated bonds. The higher the risk of a bond (the lower its credit rating), the more investors expect to be compensated for putting their money into the bond. For the insured municipal bond to be profitable for its issuer, the savings the issuer makes by offering lower interest rates must be larger than the premiums it pays to the insurer.

An insurance policy on a municipal bond also does not guarantee that a bond will reach a certain price in the marketplace. Insured bonds are still subject to changing interest rates, which affect bond prices inversely. A bond sold before it matures may be worth more or less than its par value.

Next: Municipal Bond Insurers >>

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