What Is a Guaranteed Bond?
A guaranteed bond is a debt security that offers a secondary guarantee that interest and principal payments will be made by a third party, should the issuer default due to reasons such as insolvency or bankruptcy. A guaranteed bond can be municipal or corporate and backed by a bond insurance company, a fund or group entity, a government authority, or the corporate parents of subsidiaries or joint ventures that are issuing bonds.
Understanding Guaranteed Bond
Corporate and municipal bonds are issued to raise funds from investors for a certain period of time, after which the principal investments are repaid. In effect, bonds are a financial instrument used by companies or governmental bodies to borrow money from investors. During the life of the bond the issuing entity makes periodic interest payments, known as coupons, to bondholders as a return on investment. Many investors purchase bonds for their portfolios due to this interest income that is expected every year. However, bonds have an inherent risk of default, as the issuing corporation or municipality may have insufficient cash flow to fulfill its interest and principal payment obligations. This means that a bondholder may never get his or her principal back upon maturity and may lose out on periodic interest payments.
To mitigate any default risk and provide credit enhancement to its bonds, an issuing entity may seek out an additional guarantee for the bond it plans to issue, thereby, creating a guaranteed bond. A guaranteed bond is a bond that has its timely interest and principal payments guaranteed by a third party, such as a bank or insurance company. The guarantee on the bond removes default risk by creating a back-up payer in the event that the issuer is unable to fulfill its obligation. In a situation whereby the issuer cannot make good on its interest payments and/or principal repayments, the guarantor would make the necessary payments in a timely manner. Because of this lowered risk, guaranteed bonds generally have a lower interest rate than an uninsured bond or bond without a guarantee.
Guaranteed bonds are considered very safe investments as bond investors enjoy the security of not only the issuer but also of the backing company. In addition, these types of bonds are mutually beneficial to the issuers and the guarantors. Issuers can often get a lower interest rate on debt if there is a third-party guarantor, and the third-party guarantor receives a fee for incurring the risk that comes with guaranteeing another entity's debt.