Bond Insurance is like any other type of insurance, but before we discuss it, you need to understand what a bond is. Bonds are a type of loan where you get to play the part of the bank. You lend money to an entity such as a company, a city, or even a government in exchange for payment with interest. You hold on to this bond for a set amount of time, receiving interest payments in intervals until the bond “matures.” When this happens, you are paid back the “face value” of the bond. For example, you may have heard about Victory Bonds from World War II. Patriotic citizens of the United States bought bonds to help fund the war effort and the government promised to pay them back in full with regular interest payments.
Victory Bonds may be a thing of the past, but there are plenty of other types of bonds out there that involve various amounts of risk. The safest bond you can buy is a Treasury bond issued by the U.S. Government. It’s a yield bond, which means that while the interest payments are relatively small, the bond is virtually risk-free. One type of Treasury bond, savings bonds, can either earn interest for up to 30 years or be cashed in after twelve months for its face value plus any interest it had accrued.
On the other side of the spectrum, junk bonds are high-risk and high yield. Companies looking to quickly raise capital sell junk bonds, but these companies are often young and their ability to make interest payments is dubious. Looking a company’s credit rating can help you assess the amount of risk involved. If a company defaults on their loan, you won’t get your interest payments. When a company files for bankruptcy, however, the price of the bond will drop lower than your initial investment.
All of this information comes together to explain the importance of bond insurance. You can transfer the risk of your bond from you to a company in exchange for payment. This way, if the company you loaned money to defaults, you will receive payment from an insurance company instead. It reduces the risk of potentially losing your initial investment. If you’re going to invest in bonds, you may want to insure your investment to minimize the associated risk. Consider yourself informed!