Drawbacks of Insuring Municipal Bonds

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Drawbacks of Insuring Municipal Bonds

Municipal bond issuers must pay an insurance premium to obtain insurance coverage for their bonds.

How investors pay indirectly for coverage

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.

Market behavior

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.