Bond insurance is a form of insurance purchased by bond issuers to provide extra protection to their bondholders. With bond insurance, payment of principal and interest is guaranteed by the bond insurance provider if the issuing entity defaults.
However, a company or municipality does not decide to purchase bond insurance based on a customer service perspective. The decision to purchase bond insurance is an economic decision. Since payments go to the bondholders, what’s in it for the bond issuer?
- Enhanced Ratings – Without bond insurance, the bond's rating is set through one of the bond rating companies (primarily Standard and Poor's, Moody's or Fitch). With bond insurance, the risk to the bondholder is significantly reduced and is now related to the bond insurer instead of the bond issuer.
In that case, the credit rating of the bond insurer is the relevant measure. This rating may be higher than the ratings of the bonds themselves. The ratings of the bonds in this situation are sometimes referred to as "shadow" ratings.
- Interest Payments – Bond issuers have to entice investors with a suitable rate of return, which is always going to be balanced against risk. By insuring the bonds and reducing the risk to the investor, the bond issuer can lower the amount of interest that they have to pay to attract investors.
If the savings in interest payments is expected to be greater than the cost of the insurance policy, an issuer will likely purchase bond insurance.
In short, there are two things a bond issuer asks: Do we need an improved rating to attract investors to our bonds? And, if we do attract them, can bond insurance save us money by allowing us to lower interest payments and still keep investors interested?
As a result, it is important for bond issuers – and the investment firms that underwrite their bond issues – to understand the market in which they are competing. If the bonds are attractive enough to sell as is relative to competing investments, they are unlikely to purchase bond insurance. Similarly, if they cut the interest payments so low that the bonds are unattractive compared to things like fully backed Treasury issues, they will have a hard time selling them with or without bond insurance.
From the perspective of the bondholder, it's a moot point. You don't have the choice of opting for an insured bond vs. purchasing the same bond uninsured. The bond issuer has made their choice, and either you have decided you will settle for the lower interest for the insured bond, or you will pass and invest in somebody else's bonds.
Are there risks of the bond issuer going under and defaulting? It isn't common, but it is possible. Several of the bond insurance companies suffered extensive exposure to the subprime mortgage crisis in 2007, and those companies have experienced much lower ratings (and in one case, bankruptcy of their parent holding company).
Even so, the presence of credit insurance should be reassuring to bondholders. The prior example aside, it is rare that bond insurance companies incur dramatic payment obligations. It is in their best interest to insure bonds that represent a low risk of default, and not all bonds can meet the insurers’ criteria for coverage.
So is the protection of bond insurance worth the cost? The effect may be overshadowed by the interest rate the bonds will pay. If an issuer prices their bond issue wisely, the bonds will attract investors for the minimal cost, and everybody profits. If not, bondholders are still fine, but bond issuers may suffer.