A brief bond insurance primer and why you should care…
Almost every investor has a money market account (MMA) or a bond fund. Almost everyone knows these accounts are not ordinary bank accounts and thus are not insured by the FDIC. Of course, FDIC “insurance” is a bit of a canard, as there is nowhere near enough money in reserves to pay everyone who has an FDIC insured account in the event of a sufficiently large enough U.S. banking crisis.
What most people are blissfully unaware of is that a MMA is essentially a very short term bond fund. A bond is essentially a “promise to pay” a certain sum tomorrow (over time) for a certain sum today. There are many websites that explain bond funds in hyper detail (go here for a great primer) - this is the most stripped down explanation I could think of! Bonds can be offered by many entities (corporations/governments, etc.) and are used for many purposes (capital expenditures/cash flow/reserves, etc). “Short term” refers to what is essentially a bond’s duration (which is essentially it’s “repayment period”). The duration of a MMA is usually less than 1 year. Short term bond fund duration as of this writing is about 2 years. Intermediate term bond fund duration is about 5-7 years and long term bond fund duration is 7+ to 3o years.
Let’s consider ABC Company, which needs money to manufacture a new plant. It decides to sell bonds (backed by its ability to repay) to meet its needs. It becomes the bond’s “issuer”. It will pay the bond owner interest for the use of the bond owner’s money today over the duration of the bond. But consider that ABC Company is not in the best of financial shape and would have to pay an interest rate much higher to attract an investor (who is concerned with ABC Co’s ability repay its debt, which is commonly referred to as “default risk”).
So ABC Company decides to pay to have its bonds insured with a monoline bond insurer for a fee, essentially “lending” its own credit rating to ABC Company’s bonds. Without the bond insurance, ABC would (in this hypothetical example) have to pay 8% interest on its bonds, but now that the bonds are “insured”, an investor might only be able to get 5% interest from ABC Co. since the risk of default is (allegedly) far less. ABC Company “pockets” the 3% difference, less the cost of the fee to the bond insurer.
So far, everybody’s happy, right?
- ABC Company is happy, it’s paying 5% interest instead of 8%;
- The investor is happy because the bond is “guaranteed” by a triple AAA rated bond insurer; and
- The bond insurer is happy because it charged and collected the bond insurance premium.
So what happens when the bond insurer goes belly-up? It’s a reasonable question these days and while it hasn’t happened (yet) don’t mistake the improbable for the impossible.
You see, the bond insurers have taken a bite of the sub-prime mortgage mess and the losses in this market segment may cause these insurers to lose their AAA rated credit status and even worse, may bankrupt them.
So in answer to my own question, very bad things would happen. Existing bonds would lose their insured status. New bonds would not be able to become insured, increasing borrowing costs for issuers. Investors would, in many cases, lose money (principal) on existing bonds that go into default. The shockwaves are so vast that it’s difficult to get your head around it. Our economy relies so heavily on credit that almost every industry will be effected by this in one way shape or form. Of course, as businesses are negatively impacted, employment will be as well.
The best primer I’ve found to help explain this potential meltdown can be found here. You can’t put your head in the sand on this one.