The contagion effect of default risk insurer downgrades: The impact on insured municipal bonds

Municipal bonds are often insured by insurance companies that promise to pay investors in the event of default on the part of the issuer. However, just as the financial strength of the insurer can provide assurance to investors, questions about insurer stability may heighten investor concerns. This paper considers three major downgrades to large municipal bond insurers and the effects of each downgrade on a large sample of municipal bonds. Results reveal the effects to be widespread: not only are risk premiums on bonds insured by the downgraded insurer affected, but so are those on bonds insured by other insurance companies.

Research highlights
► We analyze municipal bond insurance and its effect on insured municipal bonds.
► We question whether insurer downgrades affect the yields on the bonds they insure.
► We find that bonds insured by the downgraded insurer are affected.
► We also find that bonds insured by other insurers are also affected.