Bond Insurance: What Is Special About Munis?




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    • Nanda is from the University of Michigan Business School. Singh is from the Carlson School of Management at the University of Minnesota. The authors thank seminar participants at the Sloan School (M.I.T.), Michigan State University, University of Michigan Business School, University of Minnesota, and AFA 2000, Ioulia Ioffee, an anonymous referee, and especially Rick Green (AFA discussant and editor), for their helpful comments. We are responsible for any errors.


Close to 50% of municipal bonds are prepackaged with insurance at the time of issue. We offer a tax-based rationale for the emergence of third-party insurance of tax-exempt bonds. We argue that insurance adds value as it allows a third party to become, in a probabilistic sense, an issuer of tax-exempt securities. Insurance however reduces value by eliminating the possibility of a capital tax loss. While the net benefit from insurance increases with bond maturity, the benefit may not increase monotonically with default risk. We also provide empirical evidence supportive of the model's predictions.