What Happens if a Bond Issuer Is in Default but the Issuer's Bonds Are Insured?
Bonds represent a debt of the issuing company, organization or governmental agency. When you buy a bond, you are loaning money to the issuer in exchange for the promise to repay the face amount of the bond upon maturity plus regular interest payments. Bond issuers may purchase bond insurance that may reduce the investor's perceived risk associated with buying these bonds. Bond insurance will not prevent the underlying company from defaulting on the interest or principal payments, but it can help protect the investor against loss.
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Bond Types
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There are three primary types of bonds available to investors. Corporate bonds are issued by companies. Municipal bonds are issued by governing organizations at the state or local level. Government bonds are debt obligations of the federal government or its agencies. Government bonds involve the lowest level of risk as they are backed by the full faith and credit of the United States government. Government bonds are not insured by either government or private insurance. Corporate bonds and municipal bonds are divided into investment grade and non-investment grade or junk bonds based on the credit rating of the issuing organization. Corporate bonds rarely carry insurance in the U.S. market. Municipalities may purchase bond insurance that can raise their credit rating and reduce their interest obligations.
Default
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Bond-issuing organizations agree to make regular interest payments, which may be at either a fixed or variable rate, in addition to returning the full face value of the bond upon maturity. If the issuing organization fails to make interest payments as agreed or is unable to repay the full face value of the bond upon maturity, the issuing organization is in default of its agreement.
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Bond Insurance
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The bond insurance company steps in to protect the investor in the event an issuer defaults on an insured bond. The bond insurance company will make the defaulted interest payments to the investors as they come due until the issuing company is able to resume making interest payments. If the issuer defaults on redeeming the bonds upon maturity, the bond insurance company will pay the investor the principal amount of the bond.
Considerations
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Bond insurance companies are private insurance companies. Neither corporate bonds nor municipal bonds are insured by the Federal Deposit Insurance Corporation (FDIC) or any other agency of the federal government. The ability of bond insurance companies to meet their obligations is based on the financial assets of the company. Any investment in corporate or municipal bonds, even bonds that are insured, involves some level of risk. Insurance does not protect against market price fluctuations once the bond is issued. You may lose some or all of your investment.
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