Bond insurance, also known as financial guaranty insurance, guarantees scheduled payments of interest and principal on a bond or other security in the event of a payment default by the issuer. In return for taking on the risk, the issuer pays the insurer a premium (lump sum or instalments) to be insured. In essence, the insurance provides a “credit enhancement” that results in a higher credit rating for the bond and potentially better liquidity for investors.

In this article, we’ll take a look at bond insurance and some important considerations for individual investors in municipal (“muni”) bonds.

The majority of insured bonds are muni bonds and infrastructure bonds, after most insurers left the mortgage-backed securities market post-2008 when some ended up going bankrupt – but that doesn’t mean investors can assume all muni bonds are insured anymore.

Before the crisis, roughly 60% of all new muni bonds were insured from nine insurers, but by 2012, that number had fallen to just 3.6%, according to Reuters data. Since 2012, the figures steadily have climbed back to 6.6% and remain on the rise. Muni bond investors should never assume muni bonds are insured; it’s important to read through the bond’s prospectus to determine if it’s insured and who’s insuring it.

These things are especially important to double-check in municipalities where credit ratings may be riskier than normal. For instance, California municipalities, Detroit and Puerto Rico were relatively well-known risks before the real trouble started to surface.

Bond insurance has a demonstrated ability to stabilize bond prices during times of economic trouble, which makes it an important consideration for investors.

The two most recent examples of price stability come from Detroit’s bankruptcy and Puerto Rico’s turmoil. In Detroit’s case, the city defaulted on a few hundred million dollars worth of debt. The situation is a little more dire in Puerto Rico, where $13 billion of the country’s $72 billion debt load is insured. But bond insurers remain confident they’ll be able to weather the storm, after learning their lessons during the 2008 financial crisis.

Assured Guaranty and National bond insurance holders were kept whole, and spared the time and expense of negotiating throughout the Detroit bankruptcy, while insured Puerto Rico bonds have seen much better price stability compared to similar uninsured bonds. These are substantial benefits for individual investors, who may find it prohibitively expensive or time-consuming to fight for their shares if and when the region defaults.

The 2008 financial crisis demonstrated bond insurance was no guarantee during unforeseen magnitudes of a downturn – a recurring phenomena in the financial markets.

Bond insurers such as MBIA and Assured are publicly traded and largely depend on their credit ratings for business. If their credit ratings decline, as they did during the 2008 downturn, they may be unable to secure new business. In some cases, bond insurers have gone through Chapter 11 bankruptcy, which put their insured bonds at risk. These kinds of catastrophic downturns don’t happen very frequently, but are a risk investors should keep in mind.

Investors also lack detailed disclosures necessary to evaluate bond insurers’ abilities to make good on their guarantees. While they disclose principal and interest payments owed across their entire portfolios, interest costs aren’t disclosed for individual bonds, including some of Puerto Rico’s troubled issues. The good news is many bond insurers are working to improve transparency by spelling out their holdings in detail.

Muni bonds may be complex for individual investors to understand, especially when it comes to bond insurance issues. By keeping these three tips in mind, investors may avoid some of the common pitfalls associated with muni bond insurance and ensure better long-term returns.

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