Bond Insurance Utilization and Yield Spreads in the Municipal Bond Market

In recent years, commercial insurance companies insured nearly half of the annual issue of government bonds against bond default. This article illustrates that one impetus for the increasing popularity of municipal bond insurance is the segmentation of the municipal bond market into two markets: one characterized by an excess demand for low-risk credits and the other characterized by an excess supply of higher risk credits. The empirical findings indicate that the volume of insured bonds issued each quarter is influenced by the average yield spread between high- and low-risk municipal bonds and by the holdings of municipal bonds at financial institutions. On the other hand, the volume of insured municipal bonds issued in a quarter influences the average spread among high- and low-risk bonds. These findings underscore market segmentation and investors’ risk aversion as forces motivating the utilization of municipal bond insurance.