How Financial Guarantees Work

Generally speaking, a parent company will offer a financial guarantee of bonds issued by one of the parent’s subsidiaries, but there may be situations that may well call for a guarantee. As an example, vendors have been known to require financial guarantees from their customers when there may be uncertainty about the customer’s ability to make payments. When this situation arises, that customer’s bank will usually make a financial guarantee of the customer’s payment and will pay the vendor if the customer cannot. This is how financial guarantee insurance is designed to respond.

This doesn’t mean that a financial guarantee will always cover the entire amount of a liability. A financial guarantor might only guarantee the repayment of interest or principal, but may not cover both. In some instances multiple companies will sign on as a party to a financial guarantee. When this is the case, each guarantor is usually responsible for only a pro-rata portion of the issue. In other cases however, guarantors may be responsible for the other guarantors’ portions if they end up defaulting on their responsibility to pay.

What exactly is a financial guarantee?

A financial guarantee is often described as a non-cancellable indemnity bond backed by an insurer to guarantee investors that principal and interest payments will be made. A lot of insurance companies specialize in financial guarantees and similar products that are used by debt issuers as a way of attracting investors.

This type of guarantee provides investors with an additional level of comfort that the investment will be honored and repaid in the event that the securities issuer is not able to fulfill the contractual obligation to make timely payments. It also lowers the cost of financing for issuers because the guarantee typically earns the security a higher credit rating and therefore lower interest rates.

In most cases these bonds are insured by a financial guarantee firm (or a mono line insurer), against the possibility of a default. You may recall that the global financial crisis of 2008-09 hit financial guarantee firms rather hard. This resulted in numerous financial guarantors being left with billions of dollars of obligations to repay on mortgage-related securities that defaulted, causing firms to have their credit ratings slashed. The need for financial guarantee insurance is clearly defined by the possibility that a default could occur, and having coverage will help mitigate any losses.