How Does Insurance on Municipal Bonds Pay If Bankruptcy Is Taken on the Bond?
Municipal bond insurance is available to most municipal issuers seeking to sell debt. Insurance, to pay debt service in case of default and underwritten by strong financial companies, serves as a secondary source of security to investors. The effect of purchasing insurance is to raise the credit rating of the uninsured existing credit from average to a superior rating. By improving the credit rating of the bond, credit risk is reduced and the bond sells at a lower yield. The interest cost savings is much more than the cost of the insurance to the borrower.
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Legal Framework for Municipal Bankruptcies
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Municipal bonds may be guaranteed by the issuing authority from one or more direct sources of revenue such as a sales tax or property tax. This is called a revenue bond. General obligation bonds are full faith and credit obligations of municipalities with no direct funding source. General obligation bonds are considered safer than revenue bonds. The type of municipal bond issued is defined in the bond agreement, which includes covenants and indentures dictating the issuer's and lender's responsibilities.
Insurance
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Bond insurance is usually purchased at the time all parties agree on the bond indentures and covenants and money is ready to be transferred. In order for bond insurance to be cost-effective for the issuer, the savings to the issuer from the higher bond rating must be more than the insurance cost. Sometimes it is possible to buy insurance in the secondary market on a select maturity but this comes at a higher price to the purchaser.
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Role of the Trustee in Bankruptcy
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The appointed trustee for a bond issue, usually the trust department of a bank, is responsible for carrying out the cash transactions of the bond issue. If the trustee is informed by the issuer that there are insufficient funds to make the next payment of interest and principal the trustee calls on the insurance policy, orders the insurance company to deposit sufficient funds to the trustee account and proper bondholder payments are then made on a timely basis.
Insurance Companies Look to Recoup Losses
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Insurance companies immediately lay claim to all assets they are permitted to hold while the issuer is under duress. Meanwhile, the bond guarantor remains responsible for all interest and principal payments. The insurance company has the right to call the entire bond issue through extraordinary redemption clauses and pay off bondholders, thus avoiding many years of interest payments.
Bond Insurance is Only as Good as the Insurer
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Bond insurers receive premium income for the insurance they write. Insurers then invest those funds in reserve accounts. Bond insurance presumes a low level of defaults as the premium per issue is very small. Each default usually involves large payoffs. Insurance companies first use the invested reserve funds and if necessary, corporate capital from their own resources to liquidate the bond claim. Often, the claim is of a temporary nature, and the reserve is restored.
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