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In the secondary market, participants say they have seen several examples of municipal bonds, alike in every trait except insurance, trade at different prices. That divergence isn’t unusual. What is odd, traders and analysts say, is that the bonds lacking insurance are trading at the same prices or even higher than comparable ones carrying insurance.

Take some recent moves in Massachusetts general obligation bonds traded on the TheMuniCenter trading platform. Both carry an interest rate of 5.25% and are due in 2019. But on Thursday, the one with the lower credit rating (Aa2/AA) and no insurance was trading at a higher price — $109.445 — than the Massachusetts bond with a higher credit rating (Aaa/AAA) and insurance. The better rated, insured bond traded at $108.735.

“The bidders have chosen, to some extent, to penalize the insured bonds, when a year ago the exact opposite would have been the case,” said James Colby, senior municipal strategist at Van Eck Global, a $5.5 billion asset management firm that manages three municipal-bond exchange-traded funds.
Investors’ current disregard for insurance has translated to a sea change in the way cities, states and other governmental bodies approach their upcoming deals. Far fewer are buying bond insurance.

Since the start of this year, 39% of issued long-term municipal debt has carried credit insurance compared with 65% during the first two months of 2007. Total issuance has plunged nearly in half this year, according to data provided by the Securities Industry and Financial Markets Association and Thomson Financial.

“There’s no economic advantage for issuers to use bond insurance, by and large,” said Dick O’Brien, the Hunt Valley, Maryland-based head of fixed income at New York brokerage Folger Nolan Fleming Douglas Inc.
Issuers used to have a real incentive to buy insurance. In the past, O’Brien said his firm frequently bid on bonds where insurance made the deal more attractive to brokerages that hailed from outside the state and weren’t familiar with the municipal issuer.
Today, the same out-of-state brokerages might bid on uninsured bonds - say, an issue by Maryland’s Cecil County — but won’t be as comfortable marketing them to investors without the added guarantee of insurance. That discomfort drives up the rates issuers are paying.

In many cases, the bond insurance amounted to nothing more than a financial version of the Good Housekeeping seal of approval. It’s not a measure of a municipality’s true credit rating but it does allow them to borrow at a lower interest rate. Whether they save any money as a result of buying the insurance is up in the air. The only reason there’s even a market for bond insurance is because there are investment funds who are required to see that AAA seal of approval in order for them to buy the bond.

The big test for uninsured munis may be coming even though default rates are always low. The meltdown in real estate has the effect of lower revenue from property taxes; the minute a property is vacated, consider any tax revenue gone and the property soon to be blighted. Repeat often enough in a city with enough ambitious projects on the table and default finds itself on the table. Should this go full circle, Buffett and Ross will be the ones who the municipalities take their business to.

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