It is an interesting but little-known fact that muni bonds do not default nearly as often as corporate bonds. Muni bonds are issued by small public entities like counties, cities, water districts and the like. Corporate bonds are issued privately by corporations. Both types of bonds are issued to raise money.
There are major differences between the two categories. As was already pointed out, public muni bonds default at a much lower rate than private corporate bonds. That is a fact.
Muni bonds also carry bond insurance at starkly high premiums compared to the premiums on bond insurance for private corporate bonds. That's a major difference between the two categories right there. These and other characteristics are highlighted in years of articles posted here under the category of Bond Insurance, including for example "Municipal Bond Insurer MBIA Back in The Headlines," posted on March 21, 2012, and "Gaming the Muni System: Another Kind of Muni Bond Insurance?" posted on May 23, 2010.
Since muni bonds default far less often than corporate bonds, the comparatively higher premiums charged by bond insurance companies to munis for their bonds do not appear to be based on the lower default rate of muni bonds. The premiums charged by bond insurance companies to munis for insurance on muni bonds almost certainly have to be based on something else. Perhaps that something else is one of the constants of modern finance, return on investment or "ROI".
That would make bond insurance something like return-on-investment insurance, not insurance at all really, but something of a guarantee or hedge against an unexpectedly low return on the bond investor's investment. In this sense, muni bonds can only be sold and traded if they are backed by bond insurance, which is close to the reality of the situation. Prospects for muni bond investments in 2014 do not appear to be good, in any case. Walter Hamilton, "Investing Quarterly / Muni Bond Forecast: Cloudy in 2014 / Last Year, Bonds From States, Cities and Counties Suffered Their Worst Annual Performance Since 2008 and Only Their Fourth Losing Year Since 1990" (Los Angeles Times Online, posted Sunday, January 5, 2014).
If on the other hand premium rates for insurance on muni bonds are somehow linked to bond default performance, then premium rates for muni bonds would seem like an offer of nothing-for-something as it were. Bond insurance companies would then be charging high rates for insurance that is not necessary, if the premium rates for muni bond insurance were actually based on the chances of muni bonds defaulting, which doesn't happen as a rule.
Who ever knew that the basis for insurance premiums could reveal investment strategies or financial schemes at work?
© 2014 by Dennis J. Wall. All rights reserved. No claim to original U.S. Government works.
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