We Want To Be Your Municipal Bond Authority

A Rare Investment Opportunity

Thursday, Nov 12, 2015


● A distressed tax free municipal bond insured and guaranteed by a “AA” rated municipal bond insurer is an anomaly.

● These muni bond insurers minimize investment risk associated with bonds they insure that have become distressed.

● Distressed bonds insured by these insurers offer the investor an opportunity to earn higher than general market yields.

Insured Municipal Bonds are a $670 Billion Market The market leaders Assured Guaranty, National Public Finance Guarantee, AMBAC and Build America Mutual insure 94 % of all outstanding insured municipal bonds.

Bond Insurance Returns to Its Roots… Bond insurance was born in 1971 to provide credit protection to investment grade municipals “only.”  For a quarter of a century bond insurers built capital by insuring only low risk essential service and general obliga-tion municipal bonds whose defaults were close to zero. With insurance wrapping more than 50% of new muni issues by the mid-90s, the “AAA” rated premier bond insur-ance sector sought new avenues for further growth.  In 1995, bond insurers started writing insurance on structured mort-gage backed and international securities. By the early 2000s bond insurers were tipped more towards insuring lucrative complex structured residential mortgage backed securities than safe and steady municipal bonds. Insurers incurred lower capital charges for more profitable short term structured products which roll over more fre-quently than similarly rated longer term municipals.

The Origin of the Problem: Risky Structured Products… The house of cards imploded in 2008 when the housing market collapsed.  Major banks reported losses on subprime mortgages and other non-performing loans.  Bond insurers’ exposure to revenues from loan repayments underwritten by large banks took a capital hit. Bond insurers suffered rating downgrades. There was no longer a market for the limited, if any, credit protection insurers offered.

Bond Insurers Had Ventured Too Far… Insurers strayed away from their steady core business of insuring only investment grade muni bond debt. Exposure to poorly per-forming Mortgage Backed Securities, Collateralized Debt Obligations, and credit derivatives issued by large banks triggered the decline. These newer products simply did not meet the bond insurers’ “zero loss” underwriting standard, which was a prerequisite to their highly leveraged insurance business model, even though many of the structured transac-tions’ underlying ratings were supposedly “AAA.”

Many bond insurers were forced to exit the market and the remaining bond insurers took a step back... To write insurance again, bond insurers would need to address significant financial uncertainties. By legally challenging the  big banks on the issue of their underwriting standards on mort-gage backed bonds, many of these exposures were put back to banks or commuted.  Segregating their insured exposure to mortgages in a separate account isolated the insurers’ most significant financial problem.

The Future of Municipal Bond Insurers… Seven years on, today’s muni bond insurers have solved their structured products problems. Major uncertainties are out of the way as top bond insurers preserved capital and lowered risky expo-sures. Lessons learned along the way have taken bond insurers back to their original business model: Insure Invest-ment Grade Municipal Bonds, “only.” The bond insurers’ muni bond exposure did  not cause the strain. Bond insurers have paid investor claims on recently troubled issuers without question. Claims have been a min-iscule portion of their insured municipal bond exposure.

Bond insurers now realize that steady stable income from municipal bonds that experience close to zero defaults is a powerful stand alone business model.  Today bond insur-ance is a niche “municipal bond only” business.

Assured Guaranty: #1 Bond Insurer

Rated: Moody’s “A2” / S&P “AA” Claims Paying Resources: $12.6 billion, Net Income: $1.08 billion Investment portfolio: $11.8 billion, insured par value outstanding $390 billion, NYSE: AGO

Assured Guaranty insures 8.4% of the $3.7 trillion municipal bond market.

High Quality Insured Exposure…Assured Gty’s total insured exposure is $390 billion rated “A” average: Municipal bond exposure is approx. $310 billion average rating “A”, U.S. structured finance is approx. $40 billion average rating “AA-” and inter-national exposure is approx. $40 bil-lion rated “BBB+” to “AA-”. Only 3% of Assured’s U.S. public fi-nance exposure reflects bonds down-graded below investment grade. 

Paid All Claims… Of approximately 10,000 U.S. public finance exposures, net recovery on losses are expected to involve less than a dozen issuers. As-sured has paid claims on: Stockton, Jefferson County Sewer Authority, Harrisburg Incinerator Authority and Detroit. As a result of negotiations, over the long term, Assured is posi-tioned to make substantial recoveries on losses incurred as a result of bond holder claims on these issues. Informed GMS investors purchased these Assured  insured bonds at con-siderable discounts. Claims related to Jefferson County and Detroit were easily within Assured Gty’s reserves.

Recent Deterioration of The Credit Quality of Puerto Rico Debt… Puerto Rico bonds were investment grade when Assured Guaranty insured over $5 billion of various Commonwealth debt.  Today Puerto Rico bonds are under severe financial pressure as the Island deals with a self-proclaimed financial crisis. S&P, taking into con-sideration Assured’s exposure to Puerto Rico issuers, maintained its high quality “AA” rating on Puerto Rico bonds insured by Assured.

Claims Paying Resources Relative to Guaranteed Debt Service Highest Since 2009… Rapidly declining in-sured exposure due to refunding, terminations and scheduled amortiza-tions accelerate capital growth and lessened exposure. Assured’s current insured exposure of $390 billion is 60% of 2009 levels and is expected to go down 30% to $262 billion by 2019. Assured Guaranty’s Claims Paying Resources of $12.6 billion relative to guaranteed debt service, the highest for the insurer since 2009. 

New Frontiers… Traditionally, bond insurance was the prerogative of the issuer. Now, multi million dollar pro-fessional and institutional investors can directly purchase bond insurance on previously uninsured bonds that meet Assured Guaranty’s criteria. Assured affiliate MAC, established in 2013, will insure municipal bonds purchased in the secondary market. Assured is aggressively expanding the frontiers of bond insurance to second-ary market issues that meet its criteria. With its significant claims paying resources, Assured Guaranty has evolved as a highly rated and the most dominant municipal bond insurer.       

National Public Finance Guarantee: The Sleeping Giant…Latent But Powerful

Rated: Moody’s “A3” / S&P “AA-” Claims Paying Resources: $4.9 billion, Net Income: $238 million
Investment portfolio: $4.5 billion, insured par value outstanding $194 billion, NYSE: MBI

Winning major legal battles got National a new life…  A protracted legal battle around its 2009 split from weaker MBIA Inc. ended with favor-able settlements for National. Nation-al became separate from MBIA after the latter repaid a $1.7 billion loan to National from improved liquidity. Newly capitalized in 2009 National is a municipal only bond insurer. When parent MBIA Inc. split, National got the “good” muni exposures, while risky structured finance problems were left to affiliate MBIA. National’s leverage with a muni only portfolio is lower than pre-crisis MBIA. National has had minimal default claim payments since its inception. National’s $1.4 billion unearned pre-mium reserve and $4.5 billion invest-ment portfolio generate steady premi-um earnings and investment income. One can easily understand why both Moody’s and S&P raised their respec-tive ratings of “Baa1/A” to  “A3/AA-.”

National is well capitalized… National has solid claims paying resourc-es of $4.9 billion. Its $194 billion insured portfolio is 97% investment grade. National’s $4.5 billion invest-ment portfolio contains 76% “AAA/AA” investments.  Even without writ-ing new policies between 2008 - 2014, National is earning substantial reve-nues from its existing insured portfo-lio through premium accretion, municipal refundings, which lessen expo-sure, and investment income.

National’s Puerto Rico Exposure… National insures approx. $4.3 billion Puerto Rico bonds. Under the S&P extreme stress model National main-tains adequate capital and liquidity to cover theoretical losses on Puerto Ri-co bonds and warrants a “AA-” rating. 

National is a well respected municipal bond insurer… It has a strong capital base, stable earnings and prov-en bond insurance infrastructure. Combined with management under-writing, distribution and customer relationships, National recently re-en-tered the primary and secondary municipal bond insurance markets.

AMBAC: Represents Significant Value

Rated: “Non-Rated” Claims Paying Resources: $8.8 billion, Net Income: $484 million

 Investment portfolio: $5.5 billion, insured par value outstanding $130 billion, NASDAQ: AMBC

Reorganization eliminated risky exposures from the General Account. This added considerable value to AMBAC insured municipal bonds held in its General Account... Newly capitalized AMBAC emerged from bankruptcy in May 2013.  Risky exposure (13% of AMBAC insured exposure), primarily residential mort-gage backed securities, were taken out of the General Account and placed in a separate Segregated Account.

The General Account is now highly protected with a senior claim on AMBAC claims paying resources… 99% of AMBAC insured munis are in the secure General Account. AM-BAC’s General Account (87% of AMBAC insured exposure) is of high credit quality. AMBAC insured bonds held in the General Account are ap-proximately 89% investment grade rated “Baa” or higher making them highly unlikely to file a claim on the insurance guarantee. The claims paying resources are close to $9 billion. AMBAC’s insured exposure of $130 billion is roughly 30% of 2008 levels. Surging bond calls, debt refinancings and maturing bonds have reduced in-sured exposure by around $50 billion annually for the last six years.

AMBAC Puerto Rico Exposure… AMBAC’s Puerto Rico exposure is $2.4 billion: 90% is secured by reve-nue pledges providing adequate debt service coverage ranging from 1.6x to 2.8x; and 10% is general obligation debt which carries strong constitution-al protection. Contributing stable steady income is AMBAC’s $5.5 bil-lion investment portfolio and $1.4 bil-lion unearned premium reserve. AMBAC’s investment portfolio is 57% investment grade. Since AM-BAC no longer insures new bond is-sues a credit rating is no longer necessary. Credit ratings are costly and expensive to maintain especially when a rating serves no purpose in AMBAC’s business model. AMBAC is now in run-off mode and when all current insurance policies expire AM-BAC shareholders will benefit from a remaining assets dividend. AMBAC is very capable of paying any General Account claims, a posi-tive declaration for AMBAC insured municipal bonds and a comfort to holders of AMBAC insured bonds.

AMBAC is a good place for aggres-sive municipal bond investors to re-alize value… Even for high quality credits, sophisticated investors see the value of insurance. Insurers act as expert intermediaries between retail investors and issuers. Insured deals typically carry tougher bondholder se-curity covenants actively monitored by experienced credit analysts. Insur-ers’ surveillance of pending problems, addressed before they surface, bene-fits all bondholders and the issuer. There is a substantial demand for all AMBAC insured municipal bonds.

Build America Mutual (BAM)

Structured as a mutual company owned by the issuers it insures.  Rated S&P: “AA”

Only insuring issuers in the U.S. public finance market

Build America Mutual (BAM) estab-lished in 2012, follows a conservative strategy of insuring only tax backed U.S. state and local government obli-gations.  BAM’s $20 billion municipal bond insured portfolio carries an aver-age “A” rating.  BAM has no exposure to Puerto Rico. Claims Paying Re-sources of $586 million (6/30/15) with investments of $460 million that carry “AA” average rating.  BAM’s insurance underwriting is built on the management experience of Financial Security Assurance, a for-mer Triple-A bond insurer.  As the first mutual bond insurance company, BAM is owned by and operated for the benefit of cities, states and local governments: 1,500 government enti-ties are currently members.  BAM is sponsored by the National League of Cities; capital was funded by HG Global, an affiliate of White Mountain Capital (NYSE: WTM, Corporate Debt Rating S&P BBB).BAM’s conservative underwriting limits single-risk exposures to $115 million or 20% of claims paying re-sources.  A first loss reinsurance poli-cy collateralized with $100 million capital covers losses up to 15% of par on each BAM policy.  As a mutual company, BAM’s focus is to provide a stable, low cost financial guarantee to its owner-members rather than in-vestment returns: aligning the interests of policy holders and members  to a low risk capital centric approach. BAM’s strategic plan is well-devel-oped and its operations are well sup-ported by conservative underwriting, legal, actuarial and surveillance exper-tise. Excess capital remaining at the end of a theoretical depression after losses generated by the S&P capital adequacy model reflects extremely strong capital adequacy.As a new insurer BAM had not in-sured distressed bonds such as Detroit, Jefferson County, Stockton, CA and Puerto Rico. With current low interest rates, insurance is written on less than 7% of municipal bonds being issued.


Bond insurers’ interests are aligned with bondholders of insured distressed bonds…The quality insurers mentioned in this report can be expected to meet all claims related to the distressed bond issues they insure. Holders of insured distressed bonds rely on insurance. In distressed situations insurers fight the battle for payment with issuers / obligors. Insurers bring to the table distinct work-out teams including negotiators and legal counsel to lead creditor committees. The value of insurance is most visible with speculative grade credits that were initially insured when they had investment grade ratings.  Quality bond insurance provides excep-tional value to once investment grade now speculative bonds. Significant claims paying resources of quality bond insurers minimize debt service payment risk that speculative bonds carry. Liquidity for timely claim pay-ments comes from the insurer’s earnings from premium reserves, investment portfolio in-come and strong  statutory capital.  Chicago and Puerto Rico bonds insured by Assured, National and AMBAC are in high demand by municipal bond mutual funds. The security of claims paying ability, Assured $12.6 billion; National $4.9 billion; AMBAC $8.8 billion adds value and protection to hold-ers of insured distressed muni bonds. The high yield on insured speculative grade bonds rewards investors as quality bond insur-ance minimizes the risks associated with spec-ulative grade bonds. 

A Safety Net… Informed investors realize that top bond insurers provide several layers of protection throughout the life of the bond, which includes the financial guaranty of timely debt service payments and expert intermediation with issuers. Ambiguous headlines concerning Puerto Rico debt have had an impact on insurers and have misled already confused investors. A degree of inaccurate information has depressed the prices on insured Puerto Rico bonds. Regardless of its underlying rating a municipal bond insured by Assured is rated “AA” S&P, a bond insured by National is rated “AA-” S&P. If an insured bond should default it becomes the liability of the bond insurer, therefore insured bonds carry the rating of their ultimate guarantor, the high-ly rated bond insurer. Puerto Rico muni bonds guaranteed by Assured and National yield con-siderably more, as much as 200 basis points or 25% more, then their general market counter-parts that carry the ratings of these insurers. Based on the large appetite of the municipal bond investor and the low volume of insured new issues, prices of outstanding insured dis-tressed municipal bonds could rise.

The Need for Bond Insurance… Bond insurance is most valuable to “A” or “BBB” rated issuers who issue roughly $150 billion or 40% of municipals issued annually.  Insured bonds get a larger audience, providing more liquidity for investors and interest savings for issuers.  Insurance volume is expected to rise gradually. Assured Guaranty is expected to keep its lead, though well capitalized National could eventu-ally bring price competition. New bond insurer Build America Mutual (BAM), established in 2012 and rated S&P “AA”, is a quality insurer widely accepted by issuers and investors. 

Risk Related to This Strategy… A strategythat involves buying insured distressed muni bonds offers the investor the opportunity to purchase highly rated insured bonds at very attractive high yield bond prices. This strategy may not be suitable for all investors. Investing in insured Puerto Rico securities can involve loss of market value due to risk associated with claims paying ability of the insurer and/or volatility caused by headline risk con-cerning all Puerto Rico bonds in general. Puerto Rico debt bears various degrees of credit risk. Liquidity and inadequate cash flow could result in non-payment on some debt securities. If an issuer misses a payment on a bond insured by the mentioned insurers a holder of an insured bond can expect to be paid in a timely manner. However, the market value of the insured bond may be affected. Inflation erodes the real value of all bonds. Insured Puerto Rico bonds are no exception. However, the value of insured distressed bonds is normally not significantly affected by a rise in interest rates or inflation.

Contact a GMS Group municipal bond specialists today at 877-567-9811 to learn more about how to improve and maintain your investment portfolio.

Information obtained from sources deemed reliable; GMS does not purport to have included all available information.