Municipal bond insurance: identifying the best payment plan

Andrew Kalotay and Leslie Abreo

Journal of Risk Finance, 2017, vol. 18, issue 1, 48-54

Abstract: Purpose - The volume of municipal bond insurance declined dramatically following the financial crisis of 2008. Insurance now is making a gradual comeback. Two related considerations complicate identification of the best insurance plan. One is the current practice in the municipal market of issuing callable bonds with an above-market coupon; such bonds are very likely to be refunded. The other is that the cost of insurance may depend on when the bonds are refunded. This paper shows how contemporary fixed income analytics can be applied to identifying the best payment plan. Design/methodology/approach - When the structure of the bond issue is fixed, the benefit from insurance is simply in the increase in proceeds from the better pricing. The debt service is adjusted to incorporate the cashflows associated with insurance. The optimum time of refunding depends on the adjusted cashflows. The effective insurance cost is the difference between the present value of the debt service with and without the adjustment for insurance payments. Findings - The timing of refunding is a critical determinant of which premium payment plan is the best deal. For a given bond structure, the likelihood of refunding favors plans that are contingent on that event. Originality/value - The paper proposes an analytically rigorous approach to identifying the most cost-effective bond insurance plan. The findings are relevant to participants in municipal finance, including issuers and their advisors, underwriters and bond insurance companies.

Keywords: Advance refunding; Bond insurance; Insurance plan selection; Insuring callable bonds; Municipal bonds; OAS analysis (search for similar items in EconPapers)
Date: 2017
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Persistent link: https://EconPapers.repec.org/RePEc:eme:jrfpps:jrf-06-2016-0082

DOI: 10.1108/JRF-06-2016-0082

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