Recently, it has been shown that tethered anti-BMP2 monoclonal antibodies (mAbs) can trap BMP ligands and thus provide BMP inductive signals for osteo-differentiation of progenitor cells. The objectives of this study were to: (1) develop a co-delivery system based on murine anti-BMP2 mAb-loaded alginate microspheres encapsulating human bone marrow mesenchymal stem cells (hBMMSCs); and (2) investigate osteogenic differentiation of encapsulated stem cells in alginate microspheres in vitro and in vivo. Alginate microspheres of 1 ± 0.1 mm diameter were fabricated with 2 × 106 hBMMSCs per mL of alginate. Critical-size calvarial defects (5 mm diameter) were created in immune-compromised mice and alginate microspheres preloaded with anti-BMP mAb encapsulating hBMMSCs were transplanted into defect sites. Alginate microspheres pre-loaded with isotype-matched non-specific antibody was used as the negative control. After 8 weeks, micro CT and histologic analysis were used to analyze bone formation. In vitro analysis demonstrated that anti-BMP2 mAbs tethered BMP2 ligands that can activate the BMP receptors on hBMMSCs. The co-delivery system described herein, significantly enhanced hBMMSC-mediated osteogenesis, as confirmed by the presence of BMP signal pathway-activated osteoblast determinants Runx2 and ALP. Our results highlight the importance of engineering the microenvironment for stem cells, and particularly the value of presenting inductive signals for osteo-differentiation of hBMMSCs by tethering BMP ligands using mAbs. This strategy of engineering the microenvironment with captured BMP signals is a promising modality for repair and regeneration of craniofacial, axial and appendicular bone defects.