An insured bond is a marketable debt instrument on which the income payments are insured by a third party. Bond insurance protects bondholders from loss in the event that the bond issuer defaults on the debt payments. 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 money for projects such as 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 secured against future tax revenues, while revenue bonds are backed by income from certain projects or ventures such as tollbooth receipts or utility bill payments. Corporate bonds are backed by the financial strength of the firm that issues the bond while mortgage-backed bonds are secured against payments from commercial or residential mortgages. Generally tax backed bonds are viewed as the least risky, while mortgage-backed bonds are viewed as 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 the interest payments if the bond issuer defaults on the debt. Insurance policies are bought before the bonds are first sold so that prospective investors know that 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 place regardless of changes in ownership of the bond. A conservative investor with a low level of risk tolerance may prefer to buy an insured bond rather than an uninsured bond because the presence of insurance greatly decreases the principal risk.
The yields paid on bonds are reflective of the degree of risk that investors are forced to contend with. Low risk bonds such as the bonds issued by national governments in developed nations tend to pay lower yields because these bonds are viewed as low risk. Mortgage-backed bonds tend to pay higher yields because of the relatively high level of risk that bondholders contend with. Bondholders that purchase insurance policies can pay lower yields because the insurance policy lessens the level of principal risk. Therefore, while buying insurance can increase the bond issuer's costs, the purchase of the insurance also lowers the long-term interest expense.
Some investors perceive insured bonds to be risk free investments. In fact, bondholders can lose money on an insured bond if the insurer becomes insolvent or fails to honor its obligations. Insurance firms like bond issuers are subject to credit ratings so many investors only buy bonds that are insured by firms with good credit ratings.