Guaranteed Bond
Overview
A guaranteed bond is a debt security whose timely interest and principal payments are backed by a third party in case the original issuer defaults. Both municipal and corporate bonds can carry guarantees. The guarantor—such as an insurance company, bank, government authority, parent company, or fund—commits to make payments if the issuer becomes insolvent or otherwise cannot meet obligations.
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How it works
- The issuer (a corporation or municipality) sells bonds to raise funds and agrees to make periodic interest (coupon) payments and repay principal at maturity.
- To reduce default risk and improve creditworthiness, the issuer obtains a guarantee from a third party.
- If the issuer cannot make required payments, the guarantor steps in to pay interest and principal to bondholders.
- The issuer pays the guarantor a fee (commonly about 1%–5% of the issue) for this protection.
- The guarantor typically conducts due diligence, including financial reviews, before agreeing to guarantee the debt.
Common guarantors
- Bond insurance companies
- Commercial banks or financial institutions
- Government bodies or public authorities
- Corporate parents or affiliates backing subsidiary or joint-venture debt
- Investment funds or group entities
Advantages
- Increased safety for investors because payments are supported by an additional creditworthy party.
- Enables issuers with weaker credit profiles to access capital markets or obtain better borrowing terms.
- Often results in lower interest costs for the issuer compared with an uninsured issue (net of the guarantor fee).
Disadvantages
- Guaranteed bonds typically pay lower interest to investors than uninsured bonds because of reduced risk.
- The issuer bears extra costs (guarantor fees) that can raise the overall cost of capital.
- Securing a guarantee can lengthen and complicate the issuance process due to the guarantor’s due diligence and possible financial audits.
When guarantees are used
Guarantees are commonly used when an issuer’s standalone credit quality is insufficient to attract investors on acceptable terms, when regulatory or market requirements favor enhanced credit, or when issuers want to lower borrowing costs despite paying a guarantor fee.
Key takeaways
- A guaranteed bond transfers payment risk to a third-party guarantor if the issuer defaults.
- Guarantees improve investor safety and issuer access to capital but increase issuance complexity and cost.
- Guaranteed bonds generally offer lower yields than comparable uninsured bonds because of the reduced credit risk.