What is a Financial Guarantee?
A financial guarantee is a type of promise given by a guarantor to take responsibility for the borrower in the case of default in payments to the lender or investor. Generally, insurance companies give guarantee to back the debt of large corporations (the borrower) in payments to the market (the lender).
To understand financial guarantee better, let us assume that a company ABC promises to back the loan availed by its subsidiary company XYZ. In such a case, company ABC will be required to pledge assets that can cover the debt if company XYZ defaults payments to the ultimate lender. A financial guarantee will also increase the borrowing company's credit rating.
Understanding Financial Guarantee
Financial guarantees are often offered in the form of bonds that are sanctioned by an insurer or a financial firm to guarantee the lender at the corporate level. In a move to attract investors, many insurance firms have come up with tailored financial products that can be used by debt issuers.
This will guarantee the investors/lenders that both the interest and the principal components are repaid by the borrowers.
Also, investors can breathe a sigh of relief that their investment will be repaid by the guarantor in the event of the borrower being unable to fulfil the contractual obligations.
What You Should Know
It is not mandatory for financial guarantors to back the entire debt of the borrower. When the bonds are issued by the company as a guarantee to any defaults in repayments, the guarantor can choose to cover only the interest or principal component of the liability.
While a borrowing company can have more than one financial guarantor, it can lead to some complications as the guarantor's bond issues are computed based on the pro-rata basis.
Also, in cases where one of the guarantors default on their repayments, the other guarantor may have to be responsible for the defaulted guarantors responsibilities.
