Bank Guarantee vs. Bond: An Overview
A bank guarantee is often included as part of a bank loan as a provision promising that if a borrower defaults on the repayment of a loan, the bank will cover the loss. A bond is a debt instrument that allows an investor to lend money to a corporation or government institution in return for an amount of interest earned over the life of the bond. A bond is essentially a loan made by an investor to a corporation.
Key Takeaways
- A bank guarantee is often a component of a loan agreement whereby a bank promises to meet a borrower’s obligations if they default on the loan.
- Banks will typically charge a fee to provide a guarantee.
- A bond is used by entities to raise money. The entity issues a bond for a set amount, and the buyer of the bond essentially lends the entity the amount of the bond for a set period with a set interest rate.
- Bonds are issued by an entity at a par value, usually in denominations of $100, with a stated coupon rate.
Bank Guarantees
A bank guarantee is not a debt instrument or a loan in itself. It is a guarantee by a lending institution that the bank will assume the costs if a borrower defaults on its liabilities or obligations. A bank guarantee is often a provision placed in a bank loan prior to the bank agreeing to loan out the money. The bank will charge a fee for the guarantee.
A bank guarantee encourages companies and private consumers to make purchases they otherwise would not make, which increases business activity and consumption and provides entrepreneurial opportunities.
Commercial banks often provide bank guarantees to an individual or business owner who wants to borrow money to purchase new equipment, for example. Through the guarantee, the bank assumes liability for the debtor if they fail to meet their contractual obligations.
In other words, the bank offers to stand as the guarantor on behalf of the business customer in a transaction. Most bank guarantees charge a fee equal to a small percentage amount of the entire contract, normally, 0.5% to 1.5% of the guaranteed amount.
There are different types of guarantees including performance guarantees, bid bond guarantees, financial guarantees, and advance or deferred payment guarantees. Guarantees are used for different reasons. Often, they are included in arrangements between a small firm and a large organization. The larger organization may seek protection against counterparty risk and will require the smaller party to receive a bank guarantee in advance of work.
Sometimes a bank will require collateral to provide a guarantee. This could be in the form of a pledge agreement for assets such as stocks, bonds, or cash accounts. Illiquid assets are generally not acceptable as collateral.
Bonds
Bonds are used by governments and corporations to raise money and finance needed projects. A bond resembles an I.O.U. between a lender (the bondholder) and the borrower (the entity that issues the bond). The entity issues a bond at a par value, usually in denominations of $100 with a stated coupon rate. An investor effectively lends the bond issuer $100 and receives coupon payments from the entity that issued the bond until the $100 par value is repaid by the entity that borrowed the money.
A bond is issued with an end date, or maturity date. The maturity date is when the principal of the loan is due to be paid to the bond owner and includes the terms and amounts for the variable or fixed interest payments that will be made by the borrower. The interest payment (the coupon) is part of the return that bondholders earn for loaning their funds to the issuer. The interest rate that determines the payment is called the coupon rate.
Bonds are fixed-income securities and are one of three asset classes. The other two asset classes more familiar to investors are stocks (equities) and cash equivalents. Many corporate and government bonds are publicly traded; others are only traded over-the-counter (OTC) or privately between the borrower and lender.
Special Considerations
While governments issue many bonds, corporate bonds can be purchased from brokerages. If you are interested in finding a broker to purchase bonds, take a look at Investopedia’s list of the best online stock brokers.