Every time you go Google the question “What is bond insurance?” you will either get an insurance company that offers that kind of insurance or, you get a very complicated explanation on how it actually works. So, to make things much easier for everyone I will attempt to explain it as simple as possible. Here, you won’t find any jargons that confuse things.
What is a Bond?
Before we move on to insurance bonds we need to first understand what a bond is. The simplest term we can call bonds is “tradable debt” Let’s say for example you ask Buyer 1 a sum of $100 which you will be able to pay back in a year. Now Buyer 1 would love to lend you his money, but the only problem is that he doesn’t want to get tied down with your word since he might need the money eight months from the day of lending. So what we need to do is sell Buyer 1 a $100 bond which he will be able to sell to Mr. Buyer 2. That way, you’ll still be able to pay Buyer 2 at the end of the year, Buyer 1 is happy because he got his money back, and Buyer 2 is not worried since you’ll be able to pay him when the year ends.
So, What Exactly is Bond Insurance?
With that said, we move on to bond insurance. An insured bond is what you get from the insurance company if you have a bad credit rating. You see, if you try to sell an uninsured bond to Mr. Buyer 1 and he finds out you have a very low credit rating he’s going to ask for a high interest when you need to pay up. They do this since they’re taking a risk with you and that risk usually means not being able to get their money back. So to avoid very high interest rates or to actually get someone to buy your bond, you ask the insurance companies help.
The company will then insure your bond so you have a higher chance of selling it, which in most cases is a 100 percent chance. The premium amount insurance company asks varies. For simplicity’s sake we stick with 1 percent. So with a company backing you up who will be able to repay Buyer 1 if it so happens you are unable to do so due to lack of funds, Buyer 1 will not need to worry about his money and can now buy your bonds at a low price with a lower interest rate.
So What Happens Next?
So we sell the bond to Buyer 1 with an interest rate of 5 percent instead of 10 or 15 since he is assured he will be able to get his money back. All in all, to get the total of how much money you paid at the end of the year we add the interest we are paying Buyer 1 and the interest we initially paid to the insurance company.