Bond insurance is a contract that protects the issuer and the holder of bonds from the risk that bond payments will not be made.
Bond issues from the corporate or municipal world, or from derivative sources as with asset-backed securities and CDOs, come with the risk of default-- that is, that payments will not be made on time. The major credit ratings agencies (CRAs) assign a risk of default to each bond issue with proprietary analysis methods and ratings.
Bond issuers can pay insurance companies for protection against this risk, which will improve the ratings of the bond issue and allow them to pay a slightly lower coupon rate. In fact, once an issuer purchases financial guaranty insurance, the creditworthiness of the issuer is no longer considered in the bond’s credit rating; only the credit rating of the insurance company is important at that point.
Of course, insurance companies are in the business of charging premiums proportional to the amount of risk assumed, and not all bond issuers will find it affordable or possible to attain this coverage. Coupon rates on bonds are partially a factor of the amount of risk that an investor is being paid to assume-- higher risk of default equals a higher coupon rate required. Coupon rates are also known as nominal yields.
The additional interest rate expected for any risks above that of a risk-free instrument (10-year treasury bonds are the default risk-free instrument) is known as the risk premium.
What are Bond Ratings?
What is a Credit Rating?
What is the “Riskless” (or Risk-Free) Rate of Return?