The Effect of Private Municipal Bond Insurance on the Cost to the Issuer

Abstract

In recent years, the volume of municipal bond financing has increased dramatically. This, in conjunction with soaring interest costs and a perhaps strengthened awareness of risk by investors, has created a need for municipalities to curtail borrowing costs. One means by which municipalities have attempted to accomplish this goal is through the purchase of municipal bond insurance. Three firms offer private municipal bond guarantees at substantial premiums. It is their claim that municipalities can gain interest cost savings in excess of the fee paid for coverage.Municipal bond insurance assures timely and full payment of interest and principal to investors in the event of default by the issuer. Demand for this type of insurance has grown significantly since 1975. The actual amount by which borrowing costs are reduced, however, is largely unknown, since very little empirical evidence has been examined to determine the actual interest cost savings of municipal bond insurance. To date, only three empirical studies [3, 4, 71 have attempted to quantify the interest cost savings of private municipal bond insurance. Of these studies, none is comprehensive, nor are any firm conclusions derived. Each study attempts to accomplish a different goal, consequently there is very little collaborating evidence among them. As a result, the value of municipal bond insurance is unclear.This study uses a regression model to empirically investigate the effect of insurance on the true interest cost (TIC) to the issuer. The T I C of the issue serves as the dependent variable with independent variables reflecting characteristics of the issue, the issuer, and the market. The effect of municipal bond insurance on the cost to the issuer is captured by a dummy variable. This paper is presented in four sections. Private municipal bond insurance is discussed in Section I. Section I1 contains a presentation of the model, and the empirical results are presented in Section 111. O u r conclusions are summarized in Section IV.

The Declining Insurance Benefit in the Municipal Bond Market

“…The first approach estimates a model of uninsured bond interest rates as a function of characteristics, subsequently computing the predicted values for insured bonds; see, for example, Cole and Officer (1981) and Kidwell, Sorensen, and Wachowicz (1987). The second approach estimates a model of both insured and uninsured bonds on a function of characteristics and an indicator for whether the bond is insured; see, for example, Braswell, Browning, and Nosari (1982), Lai and Zhang (2013), and Quigley and Rubinfeld (1991). We innovate upon the latter approach by introducing a more flexible specification that allows for time-varying changes in the gradient between credit ratings and bond value.…”

An Examination of the Yield Spread Between Insured and Uninsured Debt

“…Debt insurance became available in the tax‐exempt bond market in 1971 but did not become popular until recently, when high and volatile interest rates caused state and local governments to look for ways to lower the borrowing cost on their new debt 1. This significant recent growth in the municipal bond insurance market has received close scrutiny in the literature [3, 4, 13].…”

Bond Insurance: What Is Special About Munis?

“…Much of the other existing work on the subject has focused on determining the magnitude of the issuer's savings from bond insurance. For example, see Bland (1987), Braswell, Nosari, and Browning (1982), Hsueh and Chandy (1989), Kidwell, Sorensen, and Wachowics (1987), Nathans (1992), and Quigly and Rubinfeld (1991).…”