The Mechanics of Bond Insurance

Many investors prefer to buy bonds that offer bond insurance. Bond insurance has the ability to completely alter the investment potential of a bond. Here are the basics of bond insurance and how it works.

What is Bond Insurance?

Bonds are debt instruments that are offered by corporations, municipalities and governments. An investor has the ability to purchase a bond for a specified sum of money. Then the entity pays regular interest payments to the investor, over the life of the bond. At the end of the bond term, the investor can get their entire initial investment back. The big risk with bonds is that the company that issued can file bankruptcy. If that happens, you may or may not be able to get your initial investment back. You will also lose the regular interest payments that you were receiving as well.

Bond insurance is a product that is designed to help this problem. With bond insurance, an insurer guarantees the payment of the interest and the principal on a bond even if the company goes into default. This provides investors with an added level of security when investing in bonds and makes them a very safe investment overall. Bond insurance is typically provided by the entity that is issuing the bonds instead of being purchased by the investor. 

Bond Ratings

Bonds are rated on a system that is provided by a number of financial institutions. For example, companies like Standard & Poor's, Moody's, and Fitch all have bond rating systems that go from AAA to C or D. AAA is the best rating that a bond can get and it represents a good credit risk for investors. When you are dealing with an insured bond, the bond will take the credit rating of the insurance company instead of the insured. In most cases, this means that you are going to be getting a rating of AAA on an insured bond. The insurance company is rated on their assets, liabilities, revenue and credit history. Rating systems want to see that the insurance companies have the ability to pay claims if something were to happen. 

Investment Considerations

As an investor, bond insurance adds an interesting dynamic to the process. When you purchase a bond that has bond insurance, you will be getting a very safe investment. You are basically investing in an insurance company's ability to pay the bond upon default. While you are being provided with a safer investment, you will also make less of a return on your investment. Insured bonds are going to have the lowest yield of any bonds on the market. 

If you are investing for the long-term, this could be a good investment for you. You can plan ahead and know exactly how much money you will be making from the investment. If you are saving for a specific objective, such as a college education, or a big purchase, this could be a good option for you. 

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