Bonds range in safety from U.S. Treasury bonds, backed by the full faith and credit of the federal government, to high-yield junk bonds. Corporate and municipal issuers sometimes increase the attractiveness of their bonds by insuring them. In theory, you should be able to collect 100 cents on the dollar when an insured bond defaults. In practice, your payment depends on the financial strength of the insurer.
How to Respond to a Default
If you own an insured bond that goes bankrupt, your bond broker should be able to file a claim with the insurer on your behalf. Contact your broker to ensure it is following up with the insurer to get you your money. You may have to fill out some paperwork. If you don’t use a broker, contact the insurance company directly and follow its procedure for filing a claim. You can use the CUSIP number — a unique identifier assigned to every security — of your bond to look up information about the bond, including its insurer. If you have problems with the insurer, immediately report the issue to the U.S. Securities and Exchange Commission and follow its guidance. You may have to hire a lawyer, who will get you included in any class-action suit against the issuer. As a bondholder, you receive any liquidation proceeds from a bankrupt corporation ahead of stockholders.
Issuers spend money on bond insurance to bump up their credit ratings. A higher rating increases the amount of money the issuer can raise and reduces the interest rate it must pay. Buyers accept the lower yields to the extent that they trust the insurer to pay off if a default occurs. Credit agencies such as Standard & Poor’s rate bonds and bond insurers, so bond investors are dependent on the honesty and ability of the rating agencies as well as the financial strength of issuers and insurers. The mortgage meltdown of 2007-2009 witnessed overrated bonds, bankrupt issuers and failed insurers.
In February 2013, the U.S. Justice Department filed a $5 billion lawsuit against S&P for fraudulently overrating mortgage-backed bonds in the run-up to the 2007 mortgage meltdown. In August 2012 the Federal Reserve Bank released a study indicating that, while Moody’s Investors Service, another credit rating agency, counted 71 municipal bond defaults from 1970 through 2011, the actual number was 2,521.
Several bond insurers, including Ambac, MBIA and Radian, went bankrupt or closed their doors during the 2007-2009 mortgage crisis. Investors who depended on insurance to protect their bond holdings lost principal and interest that the insurers couldn’t reimburse. A May 2012 story in the “Washington Times” reports that several of the bond insurers are back in business. New municipal bond defaults, such as those in Detroit, Stockton, Harrisburg and Puerto Rico during 2013, provide insurers with fresh opportunities to prove that they can meet their commitments.