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Background
Before the financial crisis of 2008, around 50 per cent of municipal issues by volume were insured. Several major companies competed for the business. Insured bonds were priced in the market as AAA or strong AA, depending on the credit of the insurer. Following the collapse of the large bond insurance companies' ratings (because of their exposure to mortgage-backed securities), the volume declined dramatically, reaching a low point of 3.4 per cent in 2013 (Bergstresser et al. , 2015). At present, insurance for smaller issues is making a modest comeback; the first quarter of 2016 saw about 5.9 per cent of new issues insured (Weitzman, 2016). In a departure from previous experience, insured bonds presently trade roughly as A+, rather than AA to AAA, credit. These days, the providers of insurance are referred to as financial guarantors.
Another form of financial guarantee is provided by credit default swaps. CDS are related to bond insurance; however, there are some significant differences (Schmaltz and Thivaios, 2012). For example, CDS are secondary market derivatives typically used by large investors, while conventional bond insurance applies to the primary market, and is purchased by issuers. Following the collapse of the conventional bond insurance companies, Berkshire Hathaway entered the arena by offering CDS for selected municipal bonds (Campbell, 2008). It is noteworthy that the company recently abandoned the CDS business (Durden, 2016).
Municipalities buy insurance to obtain a higher credit rating and a commensurately lower borrowing cost for a bond issue. The economic rationale for insurance is discussed in Nanda and Singh (2004). The savings arise either from a lower coupon that generates the desired proceeds or, if the coupon is fixed, a lower yield (Wilkoff, 2013) and higher price (resulting in greater proceeds or less debt issuance generating the desired amount of funds).
In recent years, it has become customary to issue municipal bonds with an above-market coupon, usually 5 per cent, at a substantial premium over par. Munis are usually callable at par after 10 years, and they may also be eligible for advance refunding. The likelihood of bonds issued with an above-market coupon being refunded is obviously much greater than those issued at par.
Investors prefer premium bonds for accounting and tax reasons, and also because...