What Is a Financial Guarantee Bond?
A financial guarantee bond, sometimes known as a bank guarantee is a legal contract made between three parties—a Principal, an Obligee and a Surety—that guarantees that the principal will pay financial obligations owed to the Obligee. The Surety is the guarantor that finances the bond, usually a bank.
How Does Financial Guarantee Bond Work?
Suppose a chain of fast food restaurants sought to expand their business by building more outlets. It would need funds to do this, funds that it may not necessarily have at the moment. If the funds are not available the business owners may seek out a loan from a bank or from investors. In this case, a financial guarantee bond ensures that the fast food company will repay that loan with interest within a specified period of time. A Surety is a bond company or sometimes a bank that guarantees that the fast-food chain can pay back the loan by financing the bond. If the fast food chain defaults in its repayment of the loan, the bank makes a claim and the Surety steps in to pay back the loan to the bank or investors. The fast-food chain is then legally bound to reimburse the Surety for the payments made on its behalf.
In this case, the fast food chain is the Principal, the bank is the Obligee, and the insurance company or another guarantor that issues the bond is the Surety.
Financial guarantees act more like a line of credit than an insurance policy, and they mitigate risk but they do not eliminate it entirely. A Guarantor may default on the payment of claims if it is too large, that is why Sureties usually only guarantee a portion of a Principal’s financial obligation, and a Principal can have different Sureties guaranteeing different portions of a financial guarantee bond.