Bond insurance is a product offered by insurance companies to help a bond issuer increase its credit rating. When a bond issue is insured, the credit rating of the issuer is “enhanced” to the insurance company’s credit rating. This is because the insurance company guarantees the repayment of the principal and interest payments of the bond in case the issuer is unable to pay, which reduces the risk of non-payment to investors.
Insurance is only feasible to issuers whose credit rating is below or on par with the rating of the insurance company.
Example:
Suppose a borrower wants to issue bonds to build a new community center. The borrower has an underlying credit rating of “BBB”. This means that while it’s still considered an investment-grade bond, it has a medium risk level and, therefore, the issuer has to sell the bond at a high yield. The issuer has to weigh the lower yield (which results in a better price) due to the insurance company's rating on the bonds, versus what the insurance company is going to charge for the insurance.
Let’s assume that based on the borrower’s bond rating, it would have to issue the bonds at a 5.00% yield to make them attractive to investors. However, the borrower could purchase bond insurance from an insurer with a bond rating of “AA+” and issue those same bonds at a 3.75% yield.
If the savings the borrower will get from the lower yield exceeds the cost of the bond insurance, it makes it worthwhile to purchase the insurance.
Issuers can improve their bond’s credit rating by purchasing bond insurance from a company with a better credit rating. By improving the bond’s credit rating, the issuer can sell the bonds at a lower yield (i.e., a higher price) to investors. If the savings to an issuer are greater than the cost of the bond insurance, the issuer benefits by insuring the bonds.