Secured Bonds
Secured bonds are those that are linked to collateral such as real estate, equipment, or other income streams. For example, mortgage-backed securities are a type of secured bond that relies on the actual assets of borrowers, such as the titles of borrowers’ homes and the income stream from borrowers’ mortgage payments.
The purpose of securing a bond is that if the issuing entity fails to fulfill interest or principal obligations, investors have the right to claim the assets of the issuing entity that will enable them to recover their money. However, this right to claim the borrower’s assets may sometimes be challenged, or the sale of the assets may not yield enough to fully pay back investors. In both cases, bondholders are likely to receive only a portion of their investment after a delay that can range from weeks to years.
Secured bonds are typically issued by corporations and municipalities. However, many corporate bonds are unsecured. In the case of municipal bonds, unsecured bonds are often referred to as “general obligation bonds,” which are supported by the municipality’s broad ability to tax. Conversely, “revenue bonds,” which rely on anticipated income from a specific project, are considered secured bonds.
Unsecured Bonds
Unsecured bonds are not secured by a specific asset, but rather depend on the “full faith and credit” of the issuer. In other words, investors are promised that the issuer will repay the debt, but they do not have the right to claim a specific collateral. However, this does not necessarily mean they are a bad investment. U.S. bonds, which are generally considered the least risky investments in the world in terms of the likelihood of default, are all unsecured bonds.
Unsecured bondholders have the right to claim the assets of the defaulting issuer, but only after higher-ranking investors in the capital structure have been paid first. For example, if Widget Corp issues both secured and unsecured bonds and later goes bankrupt, secured bondholders will be paid first. Unsecured debt is subordinate to secured debt.
Risk and Return Characteristics
Generalizations regarding the risks and return characteristics of bond debt are subject to many exceptions. For example, although secured debt poses less risk to bondholders than unsecured debt, the opposite is often true in practice. Investors buy unsecured debt based on the issuer’s reputation and economic strength. In the case of Treasury bonds, which are backed by nothing but the reputation of the U.S. government, the issuer has never failed to make a scheduled interest payment or return the principal in full upon maturity for over 200 years. With most secured bonds, the issuer’s reputation and economic strength do not justify buying the bond without security.
In either case, unsecured bonds from strong economic issuers and secured bonds from weak issuers may yield a lower interest rate at issuance than the secured bond. Lower-rated corporate bonds, such as junk bonds, always carry higher interest rate schedules at issuance. However, these generalizations are valid only to a certain extent. Some very strong institutions traditionally issue secured debt, such as quasi-governmental energy producers, and in such cases, the offered interest rate would be low for the same reason that unsecured debt might be offered at a relatively low-interest rate.
Conclusion
The best
The generalizations regarding the risks and return characteristics of secured and unsecured bonds are that debts considered to be risky will always offer relatively high interest rates, while debt issued by governments and companies with a strong reputation in the economy will provide relatively low interest rates. In both cases, the general principle applies: risks and returns are interconnected, especially in bond markets where risk and return go hand in hand.
Frequently Asked Questions (FAQs)
Why might a company want to issue secured bonds instead of unsecured bonds?
It may seem logical for a company to put its assets at risk with a bond, but the company may have an interest in doing so to reduce the cost of debt. By securing the bond with assets, the company will not have to pay investors the same level of interest for the risk in its bonds. This reduces future debt costs and frees up more cash for the company to grow its business.
What are three types of secured bonds?
Secured bonds are typically backed by municipalities, mortgages, or equipment trust certificates. Municipalities can issue secured bonds based on their ability to tax citizens to meet bond obligations. Mortgage-backed bonds rely on real estate assets. Equipment trust certificates cover assets that can be easily shipped and sold in the event of default.
Source: https://www.thebalancemoney.com/secured-bonds-vs-unsecured-bonds-417067
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