Bond insurance is a product offered by insurance companies to improve the credit rating of high-yield bonds, thereby lowering the interest rate.
In the case of bond credit ratings…
Bond insurance is a product offered by insurance companies to help a bond issuer increase its credit rating. In most cases, a company’s or municipality’s credit rating is a critical factor in determining the interest rate at which it can issue debt.
But when a company or municipality purchases bond insurance, it can issue debt based on the credit rating of the bond insurer rather than the issuer.
Bond insurance is advantageous for issuers who can purchase it for less than the amount they’ll save on bond interest by issuing debt at a lower coupon rate.
Suppose Small Town ABC wants to issue bonds to build a new community center. The municipality has a bond rating of BBB. This means that while it’s still considered an investment-grade bond, it has a medium risk level and, therefore, a higher interest rate.
Let’s assume that based on the town’s bond rating, it would have to issue the bonds at a 5% interest rate to make them attractive to investors. However, the town could purchase bond insurance from an insurer with a bond rating of AAA. and issue those same bonds at a 2% interest rate.
If the savings Small Town ABC will get from the lower interest rate exceeds the cost of bond insurance, it makes it worthwhile to purchase the insurance.
What’s important here?
A company or municipality’s credit rating is one of the most important factors that determine the coupon rate at which a bond will be issued and whether investors will see it as a high-risk bond.
In general, bond issuers with higher credit can issue investment-grade bonds with lower coupon rates. On the other hand, bond issuers with poor credit rates must issue bonds at a higher interest rate to compensate for the higher risk.
When a company or municipality purchases bond insurance, it eliminates that added risk for investors. Because the bond insurer promises to repay debts the bond issuer can’t, the bonds can be issued at the credit rating of the bond insurer rather than the bond issuer.