Bond insurance protects bondholders from loss if the issuer defaults. Governments and companies sell bonds to raise funds for projects. Bond insurers are private firms or insurance companies that sell policies to bond issuers. The yields paid on bonds reflect the level of risk investors face. Insured bonds are not risk-free, and investors should only buy bonds insured by companies with good credit ratings.
A secured bond is a tradable debt instrument in which the income payments are insured by a third party. Bond insurance protects bondholders from loss in the event the bond issuer defaults on the debt. Insurance or the lack thereof has a direct impact on the yield paid by the issuer of the bond and the marketability of the bond.
Governments and private companies sell bonds to raise money for projects like new construction and expansion projects. Bond terms range from six months to 30 years, and bondholders receive interest payments on a monthly, quarterly, semi-annual, or annual basis. Government general obligation bonds are guaranteed against future tax revenue, while revenue bonds are backed by revenue from certain projects or businesses, such as toll receipts or utility bill payments. Corporate bonds are backed by the financial strength of the company issuing the bond, while mortgage-backed bonds are secured against commercial or residential mortgage payments. In general, tax-backed bonds are considered the least risky, while mortgage-backed bonds are considered the most risky; however, all bondholders are exposed to some degree of default risk.
Bond insurers are usually private investment firms or insurance companies. The companies sell insurance policies to the bond issuer and agree to honor interest payments if the bond issuer defaults on the debt. Insurance policies are purchased before the bonds are first sold so potential investors know they are buying an insured bond from the outset. Many types of bonds can be sold on the secondary market, but the insurance remains in effect regardless of changes in ownership of the bond. A conservative investor with a low risk tolerance level may prefer to buy an insured bond over an uninsured bond because the presence of insurance greatly decreases principal risk.
The yields paid on bonds reflect the degree of risk that investors are forced to face. Low-risk bonds, such as bonds issued by national governments in developed countries, tend to pay lower yields because these bonds are considered low risk. Mortgage-backed bonds tend to pay higher yields due to the relatively high level of risk bondholders face. Bondholders who buy insurance policies may pay lower yields because the insurance policy lowers the level of principal risk. Therefore, while the purchase of insurance may increase the bond issuer’s costs, the purchase of insurance also reduces interest expense in the long run.
Some investors perceive insured bonds as risk-free investments. In fact, bondholders can lose money on an insured bond if the insurer goes insolvent or defaults. Insurance companies, like bond issuers, are subject to credit ratings, so many investors only buy bonds insured by companies with good credit ratings.
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