Credit enhancement is often used as a synonym for bond insurance, but it is the market liquidity insurers provide that really drives demand for their backing, according to a report issued last week by Roosevelt & Cross Inc.

"Currently, municipal bond insurance has less to do with the underlying credit quality of the insured bond than it does with market liquidity," said Anne Ross, vice president and manager of municipal research at Roosevelt & Cross and author of the report. "The retail market, and even institutions in large part, make investments [in insured bonds] because they don't want to be worried about someone saying ~I don't like the credit anymore.'"

When the city of Philadelphia's bonds "tanked" a few years ago, Ross recalled, the city's insured bonds went down initially and then "bounced back" a few days later and "kept chugging along as usual." The downturn was more prolonged for the city's uninsured issues.

Because of retail demand for such liquidity, Ross predicts that insured bonds will comprise about 50% of the total municipal market next year, up from around 36% in 1993.

"I don't expect there will be a tremendous reduction overall in the rate of insured bonds, despite an overall reduction in total issuance" next year, she said. "Some of the insurers, will revisit ~borderline' credits and that, in concert with retail demand, should keep growth reasonably steady."

Because of their size and name recognition, the industry's largest players - AMBAC Indemnity Corp., Financial Guaranty Insurance Co., and Municipal Bond Investors Assurance Corp. - have reaped most of the benefits from the industry's growth in recent years. As a result of the three firms' hold on nearly 90% of the insured market, the market often demands a spread of five to 15 basis points for insurance from the industry's other players, like Capital Guaranty Insurance Co. and Financial Security Assurance Inc.

Roosevelt & Cross' analysis of FSA and Capital Guaranty "fails to support so large a trading differential," Ross said in the report, and she encourages investors to purchase bonds insured by both insurers because of the higher yields.

"They should presumably all trade the same," Ross said, noting that the insurers are all rated triple-A by both Moody's Investors Service and Standard & Poor's Corp. "If you can pick a deal with FSA or Capital Guaranty that is 10 basis points off, then buy it because they'll grow into themselves."

The trading values of both FSA and Capital Guaranty have been bolstered in recent months, she said, but the gains have occurred in "fits and starts."

In the past year both FSA and Capital Guaranty have been somewhat preoccupied with revamping their ownership structures. This limited the availability of paper backed by FSA or Capital Guaranty, which crimped improvements in trading value, Ross said.

But that should change as the companies move forward, she said. In June, Capital Guaranty received all Aaa rating from Moody's to go along with its AAA from Standard & Poor's. In September, the firm completed a successful initial public offering. Both events helped improve the trading value of Capital Guaranty insurance, Ross said. Now the firm needs to increase its visibility by increasing its share of the insured market.

FSA's initial public offering is still pending, but Ross said the restructuring of the firm's commercial real estate exposure will go a long way to enhancing the market's perception of the fourth largest insurer.

"Even though the IPO has stalled, the whole restructuring has virtually removed the risk of real estate transactions," she said. "Real estate is highly speculative, but I think the way FSA has handled the situation is laudable."

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