What is an "insured" bond? How secure is the insurance?
For all practical purposes, it is important to know that there are essentially 2 kinds of risks associated with bonds: interest rate risk and credit risk.
Interest rate risk is the risk that the price of your bond declines due to a general increase in long-term interest rates. If you need to sell your bond, and rates have risen, you will lose money.
Credit risk refers to the possibility that the bond's issuer, the lender, does not make payment of interest and principal as promised.
For example, during the financial crisis holders of Lehman bonds experienced this risk first-hand when the investment bank went into bankruptcy.
Insured bonds attempt to mitigate the risk of default by having an insurance company agree to pay bondholders in the event default happens.
So, insured bonds are only a secure as (1) the underlying entity that has borrowed the money plus (2) the insurance company that provides the insurance.
During the Great Recession many bond insurers had their credit ratings reduced. In some instances, AAA-rated bonds had their ratings cut several notches to that of the underlying credit. In these cases, the bonds were no longer considered investment grade.
We are not against insured bonds as a general statement. Nonetheless, we strongly advise that investors look to the underlying entity that is backing the bonds, and make sure they are comfortable with it as a stand alone credit.
| 01.14.14 @ 18:37