THE INTEREST COST EFFECT OF PRIVATE MUNICIPAL BOND INSURANCE

Abstract

This paper examines the impact of private municipal bond insurance on the interest costs of local government bonds. Based on the examination of True Interest Costs of both guaranteed and non-guaranteed municipal bonds over a three year period, results indicate that, on average, the interest costs of guaranteed bonds are significantly less than costs estimated for bonds without such protection. Investors in insured municipal bonds seem to demand a greater risk premium for the insurance coverage as the underlying credit rating of the issue rises. The explosive post-war growth in the volume of new tax-exempt financing has generally been absorbed by domestic capital markets, except during periods of tight credit. The demand for high quality municipal issues during tight credit periods, accompanied by rising interest rates, generally creates an environment that limits the access of issuers with lower rated bonds to long-term funds having economically affordable rates that do not exceed statutory ceilings. One of several public and private responses to the problem of limited access to affordable municipal financing has been the development of private municipal bond insurance. This insurance assures investors that in the event of issuer default, bondholders will promptly receive the scheduled coupon and principal payments from the guarantor. Since 1975 the demand for municipal bond insurance has increased dramatically, due in part to shifts in investor perceptions of risk brought about by the New York City fiscal crisis and the realization that a number of other municipalities were also faced with serious financial difficulties. As more municipalities experience financial difficulties, private bond guaranty programs will become an increasingly important force in the market for taxexempt debt. Thus, it is essential that the effect of bond insurance on interest costs of guaranteed municipal bonds be examined. The intent of this study is to determine whether the use of private municipal bond insurance reduced interest costs to local government participants. More specifically, a central objective is to compare interest costs of guaranteed municipal bonds with the estimated interest costs of those same governmental units' bonds had they issued bonds without a guarantee. Results presented here indicate that, on average, the interest costs of guaranteed bonds are