An insured bond is usually a municipal bond that has its scheduled interest and principal payments guaranteed by a bond insurance company. Municipal bonds are very attractive to investors because they are extremely safe and provide tax-exempt income. When those municipal bonds are also insured, they can become even more desirable due to the additional security provided by the bond insurer. Nearly half of all municipal bond issues are of the insured variety.

Municipal bonds are issued by government entities, such as cities, counties or states. Sometimes, these government agencies get themselves into financial circumstances that require abandoning the project that the bond is tied to. Ordinarily, this would put the bondholders at risk of losing some or all of their investment. Even if the bond issuer continues to make their payments on time, they can have the ratings on their securities lowered, causing the value of the bond to deteriorate. Bondholders are also at risk from natural disasters, such as floods, fires or earthquakes, which could render the bond issuer unable to make their scheduled payments.

Enter the bond insurer, who protects the bondholder from such risks. The insurer is a company that financially guarantees the performance of the bond. The guarantee that a bond insurer makes is that the interest and principal to be paid out to the bondholder will be paid as scheduled for the full term of the bond issue. The payments are to be made at full value, and this guarantee is unconditional and may not be revoked.

Bond insurance companies carefully scrutinize every issue that comes before them. Each insurer has financial advisors and attorneys that review the bond, and they also review the government agency that issues the bond. Only high quality, investment-grade bonds are selected for insurance. If the insurer were to select bonds that came from questionable sources, they would only be putting themselves at risk. To further protect their customers, bond insurance companies typically limit themselves to the most secure and conservative investments.

Bond insurers are rated for security and performance. Typically, the highest rating a bond insurance company can achieve is Triple-A. This AAA rating marks the ability of the insurer to pay their claims. These companies deal in issues that meet or exceed the highest standards for bond security and protection for the bondholder. Bond insurers are rated at least once per year by various rating agencies and government insurance boards. The bonds themselves are also rated for quality and security, which is based on the ratings of the insurer, rather than the issuer.

There are several benefits to holding insured bonds. Besides the backing of the insurance companies which guarantee the payouts, insured bonds can often outperform uninsured bonds, especially in times of financial duress for the bond issuer. This is because insured bonds can carry more liquidity and maintain their value better than the uninsured bonds of an agency that is financially struggling for any reason. Insured bonds can also provide a good form of alternative investment when the stock market is down, or in a recession.

There are a few potential drawbacks to holding insured bonds. The yield of an insured bond is typically lower than the uninsured variety because the discount for the cost of insurance is deducted from the bond. Normally, this discount is less than $10 per $1000 of bond value. Also, while the insured bond has its payments guaranteed, there is no stipulation that a bond insurer must pay anything other than what is legally required according to the payment schedule, even if the issuer defaults.

Due to the scrutiny of bond insurers, not all types of municipal bonds may be available as insured bonds. Revenue bonds, for instance, may not be able to be insured, but might carry a higher yield which offsets the diminished security. Another potential drawback of insured bonds is that any bondholder hoping for a capital loss for tax purposes might instead consider uninsured bonds.

After all of the different aspects of bonds have been considered, it may make perfect sense for an investor to purchase insured bonds. It really depends on the goals of the investor, and how much they value the security of insured bonds against the higher potential payouts of uninsured issues.