The Role of Bond Insurance in Emerging Market Finance
Melvin J. Howard
WHAT IS BOND INSURANCE?
nExternal, independent third party credit enhancement.
nAn insurance policy provided to the investor obligating the bond insurer to pay debt service if the issuer cannot.
nIt is an unconditional and irrevocable obligation. There is no claims process, waiting period or arbitration.
nPrincipal and interest are paid by the insurer as due--there is no acceleration of payments.
nInsured bonds are rated at the bond insurer’s financial strength rating.
WHO ARE THE BOND INSURERS?
The major “monoline” bond insurers, all of whom are rated AAA by the three major credit rating agencies, are:
nAmbac -- industry founder, 100% publicly held (NYSE: ABK)
nMBIA -- largest insurer, 100% publicly held (NYSE: MBI)
nFSA -- owned by the Dexia Group (French)
nFGIC -- owned by GE Capital Corp.
nAdditional niche monoline insurers are: XL Capital Assurance (rated AAA by S&P and Fitch); Asset Guaranty (rated AA by S&P) and ACA (rated A by S&P and Fitch).
HOW BIG IS THE BUSINESS?
nOver $1 trillion of bond insurance in force
n$250 to $300 billion of gross par insured annually
nOver 90% of insurance is for debt issued in the U.S.
nHalf is for municipal bonds and half for asset/mortgage backed securities
nNon-U.S. business is growing rapidly
nPrimarily structured and infrastructure/project finance
nMost non-U.S. growth is in Europe, Japan and Australia
INTERNATIONAL NET PAR IN FORCE
CORE BUSINESS -- RISK ARBITRAGE
nBond insurers’ long-run returns depend primarily upon successful risk arbitrage--identifying when capital market pricing overcompensates for underlying risks.
nCertain types of EM market transactions offer significant risk arbitrage opportunities for the monolines.
nSuch opportunities are most likely in times of market uncertainty or in transactions that involve complex structuring, legal issues or sharing of risks among multiple parties.
BOND INSURANCE IN THE EMERGING MARKETS
nMonoline bond insurers entered the emerging markets only recently.
nAmbac provided its first guarantee for an EM transaction in 1996.
nMonoline activity in this market is growing rapidly and currently represents a significant portion of cross-border bond issuance for non-sovereign borrowers in the emerging markets.
nGiven current market conditions, many EM transactions cannot get done without bond insurance.
FOCUS OF MONOLINE EM ACTIVITIES
nMonolines have focused primarily on collateralized debt obligations (CDOs) and “future flow” transactions.
nFuture flow transactions securitize U.S. dollar-denominated export or financial receivables, capturing payment flows off-shore (which protects against government imposed restrictions on currency convertibility and transfer).
nThe recent availability of political risk insurance is enabling the monolines to guarantee more traditional forms of securitizations (such as home mortgages or equipment leases) and infrastructure projects.
PREFERENCE FOR STRUCTURED TRANSACTIONS
nMonolines have little interest in wrapping straight sovereign or corporate bonds due to the high level of “event risk”.
nMonolines prefer to insure structured transactions in which various political and country risks can be mitigated through the use of overcollaterization, cash reserves, political risk insurance, support from foreign sponsors, etc.
nStructured transactions also allow insurers opportunities for active surveillance and, if necessary, remediation.
nStructured transactions can provide for more rapid pay-off if performance deteriorates below specific “trigger” points.
ADVANTAGES OF BOND INSURANCE
nFor EM issuers:
nSignificant reduction in financing costs.
nAccess to a larger pool of investors.
nLower price/market access volatility.
nActive surveillance and remediation
nNo emerging market downgrade risk
REDUCTION IN COST OF FINANCING
nTypical pricing for an EM transaction:
nAn unwrapped “BBB” rated bond might be sold at 300 basis points over U.S. Treasury bonds whereas with an Ambac guarantee, the same bond would be rated AAA and could price in the range of T+120 bps. While part of the 180 bps saving would go to cover the costs of the guarantee, the issuer could still expect substantial savings on all-in costs.
nprice = f ( credit risk, rating, tenor, liquidity, financial market conditions, complexity of transaction, novelty of structure)
nPricing of insured EM transactions is generally higher than straight AAAs reflecting the fact that investors “look through the guarantee” to the underlying transaction.
ACCESS TO MORE INVESTORS
nThe AAA rating provided by a monoline guarantee allows the largest pool of potential investors--those who can only invest in highly rated securities--to purchase emerging market bonds.
nIf an investor is facing regulatory or internal portfolio management limits on taking additional exposure in a particular emerging market country, a monoline guarantee provides a way around this barrier.
SURVEILLANCE & REMEDIATION
nSince monolines have a great deal at stake in any EM transaction they guarantee, they undertake careful surveillance of each transaction.
nIn the structuring of EM transactions, the monolines seek to ensure that in the event of performance deterioration remedial actions can be taken and/or there is an acceleration of payout.
NO EM DOWNGRADE RISK
nInstitutional investors have recently experienced significant downgrades in their emerging market portfolios, even for highly structured transactions such as future flows structures and A/B loans or partial credit guaranteed transactions with multilateral development banks.
nWhen such structured transactions are guaranteed by a monoline, the only way a downgrade would occur is if the monoline were downgraded.
nThe monoline insurer, rather than the investor, absorbs the costs of higher capital charges in the event of downgrades.
nEmerging market bonds often have little liquidity due to the relatively small size of the issues and/or the unique nature of the credits. This is a negative feature for some investors.
nWhen EM bonds are guaranteed by a monoline, they have increased liquidity. The risk is AAA and the counterparty is well known.
ADVANTAGES TO COOPERATION BETWEEN MDBS & MONOLINES
nThe multilateral development banks are looking for acceptable ways to use their credit and risk guarantee powers to facilitate increased private sector financing for the emerging markets.
nIt takes time for the bulk of private sector investors to fully understand and properly price these transactions (due to these transactions’ complexity, novelty and dependence on the “preferred creditor” treatment afforded the MDBs).
nBy working together, the MDBs and monolines may be able to lower the cost of financing for emerging market issuers.