Journal
JOURNAL OF FINANCE
Volume 59, Issue 5, Pages 2253-2279Publisher
WILEY-BLACKWELL
DOI: 10.1111/j.1540-6261.2004.00698.x
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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.
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