Updated July 15, 2023
What are Guaranteed Bonds?
The term “guaranteed bonds” refers to debt securities with an additional third party guarantee to make the interest and principal payments if the issuer cannot meet the debt servicing obligations in time.
Guaranteed bonds are primarily of two types – municipal and corporate. Guarantees from insurance companies, group entities, government authorities or corporate parents, etc., usually back these bonds.
Explanation
Smaller and weaker entities usually require an additional guarantee for the bonds they plan to issue to mitigate any default risk and enhance credit. This risk mitigation achieves through the issuance of guaranteed bonds, wherein the timely interest and principal payments are guaranteed by financially strong third parties, such as insurance companies, banks, parent companies, etc.
How Do Guaranteed Bonds Work?
One of the most important factors of a bond is the financial security of its issuer. Guaranteed bonds help circumvent this issue by mitigating the default risk and providing credit enhancement to the bonds. When an entity intends to issue guaranteed bonds, they typically solicit a third party to make the interest and principal payments on its behalf if it fails to meet the bond payments. The guaranteeing third party then thoroughly checks the issuer to assess its creditworthiness and financial stability. If satisfied with the credit check outcome, the third party agrees to extend the guarantee for which it receives a fee. The fee the issuer pays the third-party guarantor for the protection usually falls from 1%-5% of the overall issue size.
Examples of Guaranteed Bonds
Examples of guaranteed bonds are given below:
Example #1
Let us assume that SDF Inc. is one of the subsidiaries of ABC Group. Let us assume that SDF Inc. issued bonds worth $1,500,000 that ABC Group guarantees in exchange for a fee of $50,000. If SDF Inc. cannot make the interest and principal payments in time, then ABC Group will be responsible for making these payments. This is an example of a guaranteed bond where a parent company extends a guarantee to one of its group companies.
Example #2
In Canada, the crown corporations extend financial guarantees by the federal government. If the issuer default or suffer bankruptcy, the federal government shoulders the responsibility for making the payments of the outstanding debt. Some of these major Canadian federal crown corporations that are active in the bond market include the Canada Mortgage and Housing Corporation (CMHC), Export Development Corporation (EDC), and Business Development Bank of Canada (BDBC).
Why Are Firms Issuing Guaranteed Bonds?
Bond issuance is one of the most commonly used ways for companies to raise funds. However, it is difficult for all companies, especially the smaller and weaker entities. Thus, these entities that face difficulty in raising debt finance backed by their own credit usually use the credit of a financially stronger third party, such as an insurance company, a bank, a parent company, etc. In Canada, the federal government is responsible for making the debt payments for the defaulting crown corporations. In the US, the federal government usually doesn’t extend the guarantee for the bonds issued by private corporations; the guarantors are the parent companies in most cases.
Advantages
Some of the major advantages of guaranteed bonds are as follows:
- Given the guarantee by a strong third party, the guarantor bond investors enjoy a peaceful life as they are assured of the principal and the interest payments, even in the worst-case scenario.
- The default risk is almost lowered to zero as the bondholders’ investments are secured by the issuer’s collateral security and the third party’s guarantee.
- Issuers with poor creditworthiness can issue bonds at lower interest rates due to third parties’ backing in the form of a guarantee. Otherwise, these issuers have to bear very high interest rates to attract investors to invest in their bonds without a guarantee.
Disadvantages
Some of the major disadvantages of guaranteed bonds are as follows:
- These bonds offer a relatively lower return on investment owing to the lower risk. This means that the coupon or interest payments will be lower than unguaranteed bonds.
- The bond issuer needs to pay a premium to the third party for the guarantee, which means that the cost of capital goes up compared to a bond that is not guaranteed. However, the impact of the fee paid to the third party is offset by the benefit of lower interest rates due to the guarantee.
- To obtain a guarantee, an issuer must go through a thorough background check by the guaranteeing third party. Also, the bond issuers must provide various information, including its financials, to the investors and the guarantors, which results in a time-consuming procedure.
Conclusion
So, it can be seen that the guaranteed bond investors enjoy double the security of the issuers and the guarantors in making both interest and principal payments to the bondholder. Effectively, a guarantor’s role comes into play if the bond issuer fails to meet the payment obligations for various reasons, such as insolvency, bankruptcy, etc. From the investor’s point of view, guaranteed bonds are best suited for investors who intend to invest in low-risk bonds.
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