What Are Guaranteed Bonds?
A guaranteed bond is a debt security that ensures interest and principal payments are made by a third party, should the issuer default due to reasons such as insolvency or bankruptcy. These bonds can be either municipal or corporate varieties and may be backed by bond insurance companies, funds, government authorities, or corporate parents of subsidiaries or joint ventures issuing the bonds.
Key Takeaways
- Guaranteed Security: A guaranteed bond offers a promise that, should the issuer default, a third party will fulfill its interest and principal repayment obligations.
- Applicable Issuers: Corporate or municipal bond issuers turn to guarantors—ranging from financial institutions and funds to governments or corporate subsidiaries—when their own creditworthiness is in doubt.
- Pros and Cons for Investors: While guaranteed bonds are extremely safe for investors and allow entities to secure financing on favorable terms, they typically come with lower interest rates. Issuers also incur costs, including fees to the guarantor and undergo detailed financial audits.
How Guaranteed Bonds Operate
Corporate and municipal bonds are tools used by companies or government agencies to raise funds, effectively functioning as loans. The issuer borrows money from investors who buy the bonds, agreeing to repay the principal amount at the end of the bond term. During this term, the issuing entity makes periodic interest payments, known as coupons, to the bondholders.
Many investors prefer bonds for the steady interest income. However, there’s an inherent risk of default since the issuer may be unable to meet payment obligations due to insufficient cash flow. To mitigate this risk and provide a credit enhancement, an issuer might arrange a guarantee from a third party, creating a guaranteed bond. If the issuer defaults on payments, the guarantor steps in to cover interest and principal repayments.
The issuer compensates the guarantor through a premium, usually ranging from 1% to 5% of the total bond issue.
Advantages and Disadvantages of Guaranteed Bonds
Advantages:
- High Security: Guaranteed bonds are considered highly safe investments, offering assurance through both the issuer and the third-party guarantor.
- Mutual Benefits: These bonds are beneficial for issuers with poor credit ratings, enabling them to issue debt and often at better terms. Guarantors receive a fee for assuming the risk.
Disadvantages:
- Lower Interest Rates: Due to the reduced risk, guaranteed bonds generally offer lower interest rates compared to non-guaranteed bonds.
- Higher Issuing Costs: Issuers face greater costs, including guarantor fees and required due diligence, making the process more complex and time-consuming.
Related Terms: Municipal Bonds, Corporate Bonds, Bond Insurance, Credit Enhancement, Guarantor.
