When you invest in a bond, you may worry about losing your principal and fixed interest payments if the issuer defaults. One solution is to invest in a guaranteed bond. If you’re wondering whether guaranteed bonds are right for your investment portfolio, you’ve come to the right place. We’ll cover the basics of guaranteed bonds, how they work, and some pros and cons to be aware of.
Definition and Examples of a Guaranteed Bond
A guaranteed bond is a bond that offers investors protection from default risk because it is backed by a third party. Corporations and municipalities may issue guaranteed bonds. A number of entities can guarantee a bond, including banks, insurers, subsidiary companies, and government agencies. An issuer may choose to guarantee its bonds if it lacks significant tangible assets, or it has a low credit rating or managerial troubles. Or sometimes newer companies will seek a third party to warrant its bonds so it can access financing that it may not otherwise be able to obtain. For example, suppose Company XYZ is a young corporation seeking to issue bonds to fund its growth. Because the company is new, it’s seen as a credit risk, so it would normally need to compensate investors for that risk by paying a higher interest rate. Alternatively, Company XYZ could pay a third party a commission to guarantee its bonds. Commission amounts vary depending on a number of factors, like the issuer’s credit rating and financial solvency. In exchange for the commission, the third party promises bondholders that if Company XYZ goes bankrupt or shutters operations, it will step in and make timely insurance and principal payments. Because Company XYZ has lowered the risk of its bonds, it will be able to draw investors at lower interest rates. The downside for the company is the commission costs for insuring its bonds. Also, it may take longer to issue guaranteed bonds because the warranting agency typically requires an audit. For investors, one potential drawback is that reduced risk can produce lower returns.
How Guaranteed Bonds Work
A bond is a debt instrument issued by a government, municipality, or corporation. Investors are essentially creditors who receive fixed interest payments in most cases, plus repayment of their principal investment when the bond reaches its maturity date. But if the issuer defaults, all interest and principal payments will stop while the bankruptcy process is underway. That’s where a third-party guarantee comes in. When a bond is guaranteed by a bank or insurer, interest and principal will be paid even if the issuing company defaults. The guarantee protects investors against potentially significant losses. Those who own debt that is secured by collateral get compensated before those holding bonds that aren’t backed by collateral. Having a guarantee offers protection when you own unsecured bonds.
Pros and Cons of Guaranteed Bonds
Pros Explained
Safer for investors: If you have a low risk tolerance, guaranteed bonds can be a good choice. Your principal and interest payments are backed by a third party, so you’ll get paid even if the issuer defaults. Better financing for issuers: Issuing guaranteed bonds allows a corporation or municipality with a low credit rating to obtain financing.
Cons explained
Potentially lower returns: Guaranteed bonds present less risk for investors. In investing, lower risk generally leads to lower returns. A guaranteed bond may come with lower coupon payments compared to high-yield bonds, which come with greater risk. Issuers pay a commission: Issuers typically pay a commission of 1% to 5% to a third party to guarantee their bonds. Process can be lengthy: Because obtaining a third-party guarantee usually requires an audit of the issuer’s finances, the process of issuing guaranteed bonds can be a lengthy one.
What It Means for Individual Investors
If you’re an individual investor seeking to lower the risk of investing in bonds, guaranteed bonds may be a good choice. Even if the issuer defaults, a third party guarantees that your interest payments will continue and that the principal will be repaid.
However, guaranteed corporate bonds are relatively rare. Between 1993 and 2012, just 14% of the overall corporate bond market was backed by guarantees. You’re more likely to find guarantees in the municipal bond market, where about 50% of bonds are backed by a third party.
