A bond can be secured in a number of ways. The party issuing the bond can ensure payment with its full faith and credit as with general obligation municipal bonds. Alternatively, issuers can ensure payment through revenue bonds, which use the revenue obtained from the funded projects to pay back bondholders. Bonds can also be secured through third-party beneficiaries pledges.

Finally, bond insurance is another way that debt securities may be secured. Bond insurance is a form of third-party credit enhancement. A bond issuer will purchase bond insurance to ensure payment to bondholders in the event that the issuer defaults on a payment. No matter what happens to the finances of the government or institution that issues the bond, the bond’s payments on interest and principal will be made. This also helps the credit ratings of certain bond issuers; if the insurance company backing a bond has a higher credit rating than the issuer, the bond issued will have the credit rating of the insurance company. This makes insured bonds more attractive to investors seeking a less volatile investment opportunity. Bond insurance also increases the liquidity of bonds because it is easier to sell an insured bond on the market.

Municipal bond insurance first came onto the scene in 1971 when the American Municipal Bond Assurance Corporation (Ambac) became the first company to issue such insurance. This type of insurance came to the market so that tthe Financial Guaranty Insurance Company (FGIC) and Financial Security Assurance Inc. (FSA, now known as Assured Guaranty Municipal). These companies became known as the “big four” bond insurers.

While bond insurance seems like a wonderful idea for bond issuers, it took a while for these triple-A rated insurers to catch on; in fact, in 1980, only 3% of bonds issued were insured. However, as more and more municipal bonds faced the possibility of default, bond insurance became more popular, and soon a majority of bonds issued were insured. This was evident in 1983 when the Washington Public Power Supply System defaulted on $2.25 billion in revenue bonds; most bondholders lost 60 to 90 cents on the dollar. The small amount of bonds issued that were backed by insurance saw full repayment from bond insurer Ambac. This was a watershed moment in the history of bond insurance, and the practice became more popular. By 2007, approximately 60% of bonds were insured.

These bond insurance companies did not just focus on municipal bond insurance; they also insured a variety of securities such as mortgage-backed securities and collateralized debt obligations (CDOs). Because of this, in 2007, the downfall of the housing market also affected the muni bond asset class and the insurers that backed the payments. As homeowners defaulted on mortgages, bond insurance companies were left unable to keep making payments on the securities they backed. This resulted in credit downgrades by rating agencies. In 2007, there were seven insurers rated triple-A by the major credit agencies; today there are none.

This downfall of the trustworthiness in the industry resulted in hard times for the bond insurance companies. Certain bond insurers started to fold up and declare bankruptcy. As of 2012, there is only one major player in the municipal bond insurance market: Assured Guaranty Corporation.

There are a lot of questions regarding the necessity of bond insurance for potential bond buyers. It all depends on the amount of risk an investor is willing to take on and the type of bond that might be purchased. For one, as stated above, buying a bond backed by a reliable insurer guarantees repayment of interest and principal in the face of potential default. This is a great asset for investors seeking to decrease the amount of risk in bond portfolios.

Since there is a lack of risk, however, it also diminishes the potential reward. Bonds backed by insurance usually have substantially lower interest rates. This can be fine if an investor is looking to purchase a bond with a higher risk of default; however, if a bond that is probably not in danger of defaulting in the future is insured, it brings down the interest rate unnecessarily. As such, in certain instances, this can make the bond insurance counterproductive for potential investors.

There are also questions as to whether bond insurance companies would be able to withstand the possibility of widespread defaults and government bankruptcies. States and municipalities across the country have been racking up debt, and there have been some instances of bankruptcies. It is unknown, in the face of widespread defaults, whether some of these insurers will have the cash necessary to make payment on insured bonds.

For the longest time, though there were other, smaller triple-A rated insurance companies, the “big four” were the players that insured a majority of the municipal bonds. For the most part, these big insurers would eventually acquire the smaller ones. However, after the financial crisis of 2007, these big insurers started to see downgrades to their credit ratings, which lead to bankruptcies and tough financial times. It was common that the bond insurers would either fold or see insignificant credit ratings that led to little business. The only company to break through to the other side was Assured Guaranty Corp., which acquired FSA (now known as Assured Guaranty Municipal Corp.). These insurers have the highest credit ratings and thus insure most of the municipal bonds and securities today. However, in July of 2012, a new bond insurance company was licensed, Build America Mutual Assurance Company (BAM), which intends to insure only securities with a public purpose.

Bond insurance offers a peace of mind that can certainly help many sleep better at night knowing their investment is secured. Nonetheless, bond insurance is not without its flaws and drawbacks; as such, investors need to take the time and consider their specific needs and risk tolerance before deciding whether or not bond insurance is right for them.