The Role of Bond Insurance
in Emerging Market Finance
Melvin J. Howard
October 13, 2005
Bond Insurance
The Role of Bond Insurance
WHAT IS BOND INSURANCE?
n External, independent third party credit enhancement.
n An insurance policy provided to the investor obligating the bond insurer to pay debt service if the issuer cannot.
n It is an unconditional and irrevocable obligation. There is no claims process, waiting period or arbitration.
n Principal and interest are paid by the insurer as due--there is no acceleration of payments.
n Insured 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:
n Ambac -- industry founder, 100% publicly held (NYSE: ABK)
n MBIA -- largest insurer, 100% publicly held (NYSE: MBI)
n FSA -- owned by the Dexia Group (French)
n FGIC -- owned by GE Capital Corp.
n Additional 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?
n Over $1 trillion of bond insurance in force
n $250 to $300 billion of gross par insured annually
n Over 90% of insurance is for debt issued in the
n Half is for municipal bonds and half for asset/mortgage backed securities
n Non-U.S. business is growing rapidly
n Primarily structured and infrastructure/project finance
n Most non-U.S. growth is in Europe,
INTERNATIONAL NET PAR IN FORCE
CORE BUSINESS -- RISK ARBITRAGE
n Bond insurers’ long-run returns depend primarily upon successful risk arbitrage--identifying when capital market pricing overcompensates for underlying risks.
n Certain types of EM market transactions offer significant risk arbitrage opportunities for the monolines.
n Such 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
n Monoline bond insurers entered the emerging markets only recently.
n Ambac provided its first guarantee for an EM transaction in 1996.
n Monoline 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.
n Given current market conditions, many EM transactions cannot get done without bond insurance.
FOCUS OF MONOLINE EM ACTIVITIES
n Monolines have focused primarily on collateralized debt obligations (CDOs) and “future flow” transactions.
n Future 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).
n The 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
n Monolines have little interest in wrapping straight sovereign or corporate bonds due to the high level of “event risk”.
n Monolines 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.
n Structured transactions also allow insurers opportunities for active surveillance and, if necessary, remediation.
n Structured transactions can provide for more rapid pay-off if performance deteriorates below specific “trigger” points.
ADVANTAGES OF BOND INSURANCE
n For EM issuers:
n Significant reduction in financing costs.
n Access to a larger pool of investors.
n Lower price/market access volatility.
n For investors:
n Active surveillance and remediation
n No emerging market downgrade risk
n Increased liquidity
REDUCTION IN COST OF FINANCING
n Typical pricing for an EM transaction:
n An 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.
n price = f ( credit risk, rating, tenor, liquidity, financial market conditions, complexity of transaction, novelty of structure)
n Pricing 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
n The 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.
n If 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
n Since monolines have a great deal at stake in any EM transaction they guarantee, they undertake careful surveillance of each transaction.
n In 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
n Institutional 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.
n When such structured transactions are guaranteed by a monoline, the only way a downgrade would occur is if the monoline were downgraded.
n The monoline insurer, rather than the investor, absorbs the costs of higher capital charges in the event of downgrades.
INCREASED LIQUIDITY
n Emerging 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.
n When 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
n The 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.
n It 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).
n By working together, the MDBs and monolines may be able to lower the cost of financing for emerging market issuers.
