A financial guarantee is a non-cancellable indemnity bond backed by an insurer to guarantee investors that principal and interest payments will be made. Many insurers specialize in financial guarantee insurance and other products used by debt issuers as a way of attracting potential investors. The guarantee provides these investors with the knowledge that their investment will be repaid in the event that the securities issuer isn’t able to fulfill the contractual obligation to make payments in a timely manner.
In most instances, financial guarantors disclose the scope and intent of their guarantees in financial statements. It is understood that guarantees issued between parent companies and their subsidiaries don’t have to be recorded as liabilities on a balance sheet. This simply means that, in the case of a parent company’s guarantee of a subsidiary’s debt to a third party or a subsidiary’s guarantee of the parent company’s debt to a third party or subsidiary, neither would be required to list these obligations on a balance sheet.
All financial guarantees must be disclosed
However, all financial guarantees must be disclosed, including with the nature of the guarantee (terms, history, and events that would activate the guarantee), the maximum possible liability and any provisions that might enable the guarantor to recover funds paid out in a guarantee.
When subsidiaries of a parent company issue bonds, the parent company will offer a financial guarantee of the bonds, but there may also exist other situations that might require a guarantee. For example, vendors may require financial guarantees from customers whenever there is any uncertainty about that customer’s ability to make necessary payments. In situations such as this, a customer’s bank might be willing to financially guarantee the customer’s payment and will, therefore, pay the vendor in the event that the customer cannot fulfill their obligation.
It may also be true that a financial guarantee won’t always cover the entire amount of any given liability. You may be able to make a case that a financial guarantor might only guarantee the repayment of interest or principal and not both. On occasion, multiple companies could sign on as a party to a financial guarantee. In these cases, each guarantor could be responsible for only a pro-rata portion of the issue. Guarantors may be held responsible for another guarantors’ portions if they default on their responsibilities, a prime example of how financial guarantee insurance will see that the debt will be paid.