Selecting the Best Bond Insurance Payment Plan
For refundable munis, option-based analytics are essential.
by Andy Kalotay and Leslie Abreo
According to a Bond Buyer report in January, the level of insured municipal bonds was relatively unchanged in 2016, but the volume has seen modest increases since the dramatic decline following the 2008 financial crisis. As more municipalities buy insurance to obtain a higher credit rating (albeit, at most a bump up to AA, post-crisis) and lower borrowing cost, selecting the best payment plan can be a complicated matter.
The complexity of identifying the best premium payment plan arises from the combination of two factors: longer-term munis may be refunded prior to maturity, and the cost of some payment plans depends on the timing of refunding, which is uncertain.
Munis are normally callable at par after 10 years, and they may also be eligible for advance refunding. In addition, the current practice of issuing bonds with an above-market (5%) coupon dramatically increases the likelihood of refunding.
Turning to insurance payment plans, there are three basic structures: i) the entire premium paid upfront, ii) a smaller upfront premium, followed by an annuity commencing on the call date, and iii) a larger upfront premium, part of which can be credited, upon refunding, towards insuring the replacement issue.
In a recent paper in The Journal of Risk Finance, Andy Kalotay and Leslie Abreo propose an analytically rigorous approach to identifying the best plan. The basic idea is to incorporate into the debt service the cash flows associated with insurance. The optimal time of refunding, which can be determined by option-based analytics, depends on the adjusted cash flows.
The findings are relevant to participants in municipal finance, including issuers and their advisers, underwriters, and bond insurance companies.
If you are interested in seeing this technology in action, try out Kalotay’s free Muni Insurance Evaluator (MINER). It employs option-based analytics to identify the plan with the biggest bang for the buck.
Municipal Bond Insurance: Identifying the Best Payment Plan is available through The Journal of Risk Finance on the Emerald Insight website: http://emeraldinsight.com/doi/abs/10.1108/JRF-06-2016-0082