What Is a Guaranteed Bond?
Let me explain what a guaranteed bond is. It's a type of debt security that comes with a secondary guarantee, ensuring that interest and principal payments will be made by a third party if the issuer defaults for reasons like insolvency or bankruptcy. You can find these in municipal or corporate forms, backed by entities such as bond insurance companies, funds, group entities, government authorities, or corporate parents of subsidiaries or joint ventures.
Key Takeaways
- A guaranteed bond is a debt security which promises that, should the issuer default, its interest and principal payments will be made by a third party.
- Corporate or municipal issuers of bonds turn to guarantors—which can be financial institutions, funds, governments, or corporate subsidiaries—when their own creditworthiness is weak.
- On the upside, guaranteed bonds are very safe for investors, and enable entities to secure financing—often on better terms—than they'd be able to do otherwise.
- On the downside, guaranteed bonds tend to pay less interest than their non-guaranteed counterparts; they also are more time-consuming and expensive for the issuer, who has to pay the guarantor a fee and often submit to a financial audit.
How a Guaranteed Bond Works
Corporate and municipal bonds are tools that companies or government agencies use to raise funds. Essentially, they're loans where the issuing entity borrows money from investors who purchase the bonds. This loan runs for a set period—the bond's term—after which you, as the bondholder, get repaid your principal, the original amount invested. During the bond's life, the issuer makes periodic interest payments, called coupons, as your return on investment.
Many investors add bonds to their portfolios for the steady interest income they provide each year. But remember, bonds carry a default risk. The issuing corporation or municipality might lack the cash flow to meet interest and principal obligations. If that happens, you could miss out on interest payments, and in the worst case of default, you might never recover your principal.
To reduce this default risk and boost the bond's credit, an issuer might seek an extra guarantee, turning it into a guaranteed bond. This means the bond's timely interest and principal payments are backed by a third party, like a bank or insurance company. The guarantee eliminates default risk by providing a backup payer if the issuer can't meet its obligations. If the issuer fails on payments, the guarantor steps in and handles them promptly.
The issuer pays the guarantor a premium for this protection, typically between 1% and 5% of the total issue amount.
Advantages and Disadvantages of Guaranteed Bonds
Guaranteed bonds are seen as very safe investments because you, as the investor, have the security of both the issuer and the backing entity. These bonds benefit both issuers and guarantors. They allow entities with poor credit to issue debt they might not otherwise access, and often on better terms. You might notice issuers get lower interest rates on such debt thanks to the third-party guarantor, and the guarantor earns a fee for taking on the risk of backing another entity's debt.
However, there are downsides. Due to their lower risk, guaranteed bonds usually offer a lower interest rate than uninsured or non-guaranteed bonds. This reflects the premium the issuer pays to the guarantor. Getting this backing increases the cost of raising capital for the issuer and can make the process longer and more complex, as the guarantor will conduct due diligence, reviewing the issuer's financials and creditworthiness.
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