Determining the Cost Effectiveness of Bond Insurance
By Dean Soukup
May 25, 2004, 10:43
The decision to insure a bond issue depends largely on the cost effectiveness of the insurance premium. Munex has tools to assist in determining the break-even cost of bond insurance.
The Cash Flow Comparison Report compares the cash flows for an Insured issue against those of an Uninsured issue for each payment date, and calculates the present value of the corresponding savings or loss. The total of these figures indicates whether insurance is a net present value benefit or cost to the transaction.
Certain situations, such as when an issuer is contemplating insuring only specific maturities, require more detail than the overall savings for an issue. Munex’s Comparison of Insured vs. Uninsured Maturities report provides savings information for each maturity.
Since each report is calculated from a different perspective (i.e. aggregate cash flows versus individual maturities’ cash flows), the results, while typically similar, are not intended to be identical. Depending on the issuer’s goals, either analysis - or even both together - can provide a more complete picture of the cost/benefit of bond insurance
Setting Up and Solving
For either report, two issues must be structured in Munex: an Uninsured and an Insured issue. Typically users can simply structure the Uninsured issue first, then clone it to create an Insured issue, to which the insurance premium would be added and the revised scale would be entered to reflect the lower borrowing cost. Both issues can be solved using either an Optimal Size or Debt Service solution, although it’s recommended to use the same solution and amortization methods for both issues.
Cash Flow Comparison
To create the Cash Flow Comparison report, simply click Solve >> Cash Flow Comparison on the toolbar. Since Munex defaults to discounting the cash flows back at the AIC of the current issue, many users prefer to run this report from the Insured issue – although the discount rate can be easily adjusted, if desired. Next, define the two cash flows to compare by selecting the ‘New Issue’ button (typically defined as the Insured issue) and then selecting the ‘Old Issue’ button (the Uninsured issue).
Once the New and Old Cash Flows have been assigned, the comparison is automatically displayed on the left side of the screen. The total PV Savings number is the amount of savings/dissavings associated with insuring the transaction. Since the insurance premium is typically sized into the bond issue, there is usually no need to deduct the cost of insurance from the Total PV Savings figure.
This report can be printed directly from the comparison utility by clicking the ‘Print’ button. Additionally, the report can be printed, along with other reports, from the normal print screen by clicking on File >> Print >> Aggregate >> Comparison.
Comparison of Insured vs. Uninsured Maturities
The Comparison of Insured vs. Uninsured Maturities report is accessed by going to File >> Print >> Expense >> 8 – Comparison of Insured vs. Uninsured. The first window prompts the user to select the Insured issue; the next screen asks for the Uninsured issue.
A more detailed explanation of terms follows, but the report provides a quick and simple indication in the ‘Insure?’ column of whether bond insurance is cost effective for the respective maturity. Additionally, the ‘Amount Saved by Insuring’ line item at the bottom of the report reflects the benefit of insuring the entire transaction.
Identifies the maturity being compared. To accommodate changes in par value between the Insured and Uninsured issues, the analysis by maturity is calculated on a per bond, or $5,000, basis.
Identifies the Yield that equates the future value cash flows of one bond ($5,000) to the purchase price less the allocable insurance premium.
Identifies the Yield that equates the future value cash flows of one bond to the purchase price. This typically corresponds closely to the yield displayed on the pricing summary report.
Identifies whether the insurance premium is cost effective for the specified maturity. Essentially, indicates if the Uninsured yield is greater than the Insured Yield.
Value of Insuring
Applies the Uninsured Yield to the cash flow of the Insured maturity. From this present value figure we subtract the Insured maturity’s original dollar price less allocable insurance premium to derive the Value of Insuring.
Break Even Premium
Similar to ‘Value of Insuring’ above, the Uninsured Yield is applied to the total cash flow of the respective Insured maturity. The resulting present value figure is subtracted from the dollar price at issuance of the Insured maturity, which is then expressed as a percentage.
Total Issue Break Even Bond Insurance Premium
Takes the weighted average of the ‘Break Even Premium’ above to determine the issue level break even premium.
Current Bond Insurance Premium
The user-defined bond insurance premium.
Amount Saved by Inuring
Sum of ‘Value of Insuring’ column above.
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