What is an Assumed Bond?
An assumed bond is a special kind of bond. One company issues it but another company has to pay it back. It’s like your friend borrowing money but promising you’ll pay it back if they can’t. The two companies have to be really close, like family. A parent company and its subsidiary count. So do two companies working together as partners.
Why Would Companies Use an Assumed Bond?
Companies use assumed bonds for a few reasons:
The smaller company may get a better deal this way. Lenders charge less interest if a bigger, stronger company promises to pay them back.
It can be easier and quicker than the small company getting its own loan or bond. Less paperwork and hassle for them.
The bigger company stays in control. They can decide how much the smaller company borrows. And they can make sure the money is used how they want.
What are the Risks?
Assumed bonds can be risky for the big company making the promise. Some things to watch out for:
The smaller company could borrow too much and get into trouble. Then the bigger company has to clean up the mess. They’re on the hook for paying it all back.
Sometimes the link between the two companies isn’t clear. Like with joint ventures or partnerships. If things go bad, the big company might say “not my problem”. But legally, a deal is a deal. They have to pay up.
Accounting for assumed bonds can get tricky. They might be hiding off the main balance sheet. Investors don’t get the full picture. This is why details have to be shared in the notes to the financial statements.
How Assumed Bonds Work
Let’s say Little Co. needs cash to grow. They could issue a bond themselves. But Big Co., their parent company, steps in to help.
Big Co. says “We’ll guarantee it”. They sign on as the backer of Little Co.’s bond. It’s like Big Co. co-signing on Little Co.’s loan. So officially it’s Little Co.’s bond. But really it’s Big Co. that’s on the line for paying it back.
That backing from Big Co. makes the bond less risky for lenders. So they charge a lower interest rate than Little Co. could get alone. That lower rate saves Little Co. money. And it’s all thanks to Big Co.’s assumed bond.
The Nuts and Bolts
Usually, the interest and principal on an assumed bond works like any other bond. The smaller company that issued it cuts the checks to bondholders. They make the scheduled interest payments and pay back the principal when due.
The bigger company doesn’t pay unless the smaller one can’t. The bigger company only has to cover missed payments. It’s a backup, not the main way of paying.
If the smaller company goes belly-up, the assumed bond is treated like its other debts. Bondholders get in line with other creditors to get what they can from liquidating assets. If there’s not enough to go around, the bigger company has to make up the difference.
The Accounting Angle
The smaller company that issued the bond is the one that shows it on their books. It sits on their balance sheet as a liability. The interest they pay is an expense on their income statement. The bigger company’s accounting stays clean. At least at first.
But here’s the tricky part. That assumed bond is still a risk for the bigger company. They’ve made a promise to pay if needed. That promise, even if they never pay a dime, is worth something. Investors want to know about it.
So the larger company has to fess up in the footnotes to their financial statements. They disclose the details of the assumed bond. How much is outstanding, when it’s due, and other key terms. It’s out of sight in the main numbers but not out of mind.
If the smaller company did default, then the assumed bond hits the big company’s books in full force. Now it’s their liability. They show it on the balance sheet and take over all the payments. The footnote becomes the headline.
Conclusion: Handle With Care
When one company takes on the bond of another, it’s no small matter. The assumed bond links the two together, for better or worse. The smaller company gets a boost from the bigger one’s creditworthiness. But the bigger one is putting its own credit on the line.
The arrangement makes most sense when the two companies are already closely tied. With parent-subsidiary links or joint venture partnerships, their fates are already bound together. The assumed bond is a financial tool to make those ties even tighter.
But therein lies the risk too. If the smaller company struggles, the bigger one pays the price. And in the meantime, assumed bonds can mask the true obligations at play. They are also complex for investors to understand and analyze.
So assumed bonds are a handy option to have. In the right situation, they can fund growth and cement important business relationships. But like any complex financial arrangement, companies and investors both need to go in with eyes wide open. Know what you’re getting into. Structure it carefully. And keep close track as the bonds, and the business ties, play out over time.
