A "letter bond" refers to a type of financial instrument that combines the characteristics of both a letter of credit and a bond. It is a legally binding agreement between two parties, usually a company or government entity and an investor, whereby the issuer guarantees to make timely payments of interest and principal to the bondholder.
In this arrangement, the issuer provides a written guarantee, referred to as a letter of credit, which serves as collateral for the bond. This letter of credit is usually issued by a financial institution on behalf of the issuer, and it essentially commits the institution to making payments if the issuer defaults. The letter of credit adds an extra layer of security for the bondholder, reducing the risk of non-payment.
Letter bonds are often used to attract investment in situations where the issuer may have a lower credit rating or is considered to have a higher risk of default. By providing a letter of credit, the issuer can entice investors who may be hesitant to invest directly in the bond without the added security.
Investors in a letter bond receive periodic interest payments over the bond's term, and upon maturity, they receive the principal amount of their investment. If the issuer defaults, the financial institution issuing the letter of credit steps in to honor the payment obligations, ensuring that investors do not suffer financial losses.
Overall, a letter bond combines elements of a bond and a letter of credit to mitigate risk and enhance the attractiveness of a bond investment for potential buyers.
