Guaranteed Bond Meaning
A guaranteed bond is a bond that is guaranteed by another entity (usually a bank, a subsidiary companySubsidiary CompanyA subsidiary company is controlled by another company, better known as a parent or holding company. The control is exerted through ownership of more than 50% of the voting stock of the subsidiary. Subsidiaries are either set up or acquired by the controlling company., or an insurance company) in case the issuer of the bond defaults to make the repayments as a result of business closure or insolvency. The entity that guarantees the bond is referred to as the Guarantor. The premium paid depends on the creditworthiness of the bond issues, and if the finances of the business are in good shape, the premium charged will be much less, ranging from 1 % to 5%.
Example of Guaranteed Bond
The state of Mississippi requires funds to create a cycling track and joggers’ park along with a community hall. The project has been approved by the officials and has been named ‘Mississippi Greens.’ Since this is a project for the welfare of the people, the officials have decided to procure funds by way of issuing bonds in the market.
The bonds will be issued in a series of bonds with maturities ranging from 5 to 15 years. They have decided to issue fixed interest rate bonds, fixed to floating interest rate bonds, floating interest rate bonds, and variable interest rate bonds. Since the officials want to borrow at the lowest possible rate, they are looking to issue a variety of bonds with different features.
- One tranche has only fixed-rate bonds with an interest rate of 6%. The maturities for these bonds range from 10 – 15 years.
- One tranche has only floating rate bonds with interest rates linked to the Libor rateLibor RateLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions.. The maturities for these bonds range the same as above, i.e., 10 – 15 years.
- The final tranche has only fixed-rate bonds with a guarantee by the government. These bonds bear an interest rate of 3.5 % – 4%, and the maturities for these range from 5 – 15 years.
Usually, municipal bonds Municipal BondsA municipal bond is a debt security issued by a national, state, or local authority to finance capital expenditures on public projects related to the development and maintenance of infrastructures such as roads, railways, schools, hospitals, and airports. do not bear an interest above 4% since these have the goodwill of the municipality or the state that issues these bonds. If these bonds have a guarantee backing the payments, then the risk is practically negated since it is backed by the Government.
Investors looking for a low-risk investment can invest in the final tranche with a guarantee since it is like a fixed deposit that will give returns at regular intervals.
- The investor can rest assured that his/her investment is in safe hands, and even in the worst scenario, the principal and the interest payments would be paid by a third party, which has guaranteed the payments.
- Risk is lowered since the bondholder not only has the security of the issuer, making the payments but also the guarantor.
- Guaranteed bonds enable investors with poor creditworthiness to issue a bond with a guarantee, thereby attracting investors to invest in the bonds that pay a lower interest rate, which otherwise would bear more interest without the guarantee.
- As the risk is low, the return on investment is low, which means the interest payments are relatively low when compared to bonds that are not guaranteed.
- From the bond issuer’s point of view, having a guarantor increases the cost of procuring the capital, which in other cases, can be either issued without guarantee. In either case, the cost gets offset since a bond with no guarantee bears a higher interest, whereas a guaranteed bond bears a lower interest but with the cost of the premium that is paid to the guarantor.
- It involves a lot of procedures to obtain a guarantee since the guarantor would conduct a thorough check on the issuer’s creditworthiness and financial stability. For a normal bond, the issuer can get away with this hassle of additional documentation.
- The bond issuer has to provide information regarding it’s financials not only to the investors but also to the guarantors, which can impact the image of the issuer in case the financials are not in good shape.
Important Points of Guaranteed Bond
- Guaranteed bonds have additional security for the investor’s invested money since it is not only assured by the issuer of the bond but also guaranteed by the guarantor.
- It benefits not only the bond issuer but also the bond guarantor since the issuer gets to borrow at a lower interest rate, and the guarantor receives the fee or premium for imbibing the risk of guaranteeing the debt of another entity.
- Guaranteed bonds are most sought after by investors that wish to invest in securities with low risk for the long term. The investment pays at regular intervals, and the risk of defaultRisk Of DefaultDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors. is very minimal.
- In the United Kingdom, a guaranteed bond refers to the fixed-rate bonds, which mean the fixed interest on the bond is guaranteed, whereas, in the United States, a guaranteed bond refers to the guarantee by a third party on the interest payments and the principal amount itself.
- Even the most secure bonds issued by a company with a weak financial history can find it difficult to sell the bonds without a third-party guarantee.
Guaranteed bonds are bonds that have double security of the bond issuer and the guarantor in making the interest payments and the principal payments to the bondholder in case the bond issuer fails to make the payments owing to insolvencyInsolvencyInsolvency is when the company fails to fulfill its financial obligations like debt repayment or inability to pay off the current liabilities. Such financial distress usually occurs when the entity runs into a loss or cannot generate sufficient cash flow. or bankruptcy. These types of bonds usually allow the bondholders the luxury of having a low-risk investment, which pays a low return for long periods.
Investors that look for lowered risk investments for the long term can opt to invest in guaranteed bonds since it bears minimum risk as compared to other bonds that are not secured or guaranteed. As per the market standards, when the risk is low, so is the return. For the bond issuer, the lowered interest comes at a cost, which is the premium that needs to be paid to the guarantor. The term guaranteed bond has different meanings in the United States and the United Kingdom. For the latter, it means a fixed interest-bearing bond.
This has been a guide to Guaranteed Bonds and its meaning. Here we discuss the practical example of a guaranteed bond investment along with the advantages and disadvantages. You can learn more about financial bonds from the following articles –