Bonds are debt instruments used by governments and companies to raise funds for projects. The level of risk and yield varies depending on the type of bond, with bond insurance reducing principal risk and potentially lowering yields. Bond insurers are private investment firms or insurance companies, and their credit ratings are important to investors.
A secured bond is a negotiable debt instrument on which income payments are secured by a third party. Bond insurance protects bondholders from loss in the event the bond issuer defaults on debt payments. The insurance or lack thereof has a direct impact on the yield paid by the bond issuer and the marketability of the bond.
Governments and private companies sell bonds to raise funds for projects such as new construction and expansion projects. The terms of the bonds range from six months to 30 years, and bondholders receive interest payments on a monthly, quarterly, semi-annual, or annual basis. General government bonds are secured against future tax revenues, while revenue bonds are secured by revenues from certain projects or initiatives such as toll booth revenue or utility bill payments. Corporate bonds are secured by the financial strength of the company issuing the bond, while mortgage-backed bonds are secured by commercial or residential mortgage payments. Tax-backed bonds are generally considered to be the least risky, while mortgage-backed bonds are considered to be the most risky; however, all bondholders are exposed to some degree of default risk.
Bond insurers are usually private investment firms or insurance companies. Companies sell insurance policies to the bond issuer and agree to make interest payments if the bond issuer defaults. Insurance policies are purchased before the bonds are first sold so potential investors know they are buying an insured bond from the start. Many types of bonds can be sold in the secondary market, but the insurance remains in effect regardless of changes in bond ownership. A prudent investor with a low risk tolerance may prefer to buy a covered bond over an uninsured bond because the presence of insurance greatly reduces the principal risk.
The yields paid on bonds reflect the degree of risk investors are faced with. Low-risk bonds such as bonds issued by national governments in developed countries tend to pay lower yields because these bonds are seen as low-risk. Mortgage-backed bonds tend to pay higher yields due to the relatively high level of risk faced by bondholders. Bondholders who buy insurance policies may pay lower yields because the insurance policy reduces the principal level of risk. Therefore, while buying insurance may increase the bond issuer’s costs, buying insurance also reduces long-term interest expense.
Some investors perceive covered bonds as risk-free investments. Indeed, bondholders can lose money on a covered bond if the insurer defaults or defaults on its obligations. Insurance companies like bond issuers are subject to credit ratings, so many investors only buy bonds that are insured by companies with good credit ratings.
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