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A bond is a debt security, which is commonly issued by government agencies as well as companies. Regardless of the issuing entity, all of these securities fall into two overarching categories: secured and unsecured bonds. If you're thinking about investing in a bond, it's important to understand the risks, rewards, advantages, and disadvantages of both secured and unsecured bonds.
In this publication, we're going to talk about the differences between secured and unsecured bonds. As part of that explanation, we'll also provide some practical examples for each type of bond. We'll then talk about the pros and cons of holding each bond type. We'll finish up with a discussion of the factors to consider before purchasing a bond.
Secured Bonds
When a bond is backed by a specific asset, it is termed a secured bond. Typical assets include cash or physical property, such as plant equipment or machinery. A secured bond tells the investor that something of value will be available to bondholders in the event the issuer cannot pay the interest owed, or repay the principal balance.
Secured Bond Examples
A government agency may decide to build a new bridge to span a waterway and connect two cities. That agency may issue bonds to help finance the construction of that bridge. The bonds could be secured by the toll charges collected from motorists traveling across the bridge. In this first example, the bond would be secured by a future revenue stream (cash). This type of bond is sometimes referred to as a revenue bond.
Companies can also purchase real estate or other mortgageable property. In this example, the company may decide to use the real estate as collateral. This is accomplished through a mortgage bond. If the company defaults on this bond, the bondholders can collect a share of the money they're owed by foreclosing on the property.
Mortgage Bonds
The category of mortgage bonds can be further subdivided into junior and senior debt, also referred to as a first mortgage. If the issuer of the bond is forced to liquidate their real estate holdings, the holders of senior debt (first mortgages) are paid before the holders of junior mortgage bonds.
Unsecured Bonds
An unsecured bond, also referred to as a debenture, is not backed by an asset of any kind. If bankruptcy occurs, repayment is not guaranteed by a future revenue stream, equipment, or property. An unsecured bond is only backed by the full faith and credit of the issuing institution.
Unsecured Bond Examples
U.S. Treasury securities such as bills, notes, and bonds are good examples of unsecured debt. The only guarantee of repayment is the trust that investors have in the federal government. Although unpopular with taxpayers, the federal government always has the option of raising income taxes to meet its financial obligations.
An income bond is another example of an unsecured bond. These securities are issued by companies, and the payment of interest is contingent upon sufficient earnings. Also known as an adjustment bond, these bonds are frequently issued by corporations attempting to maintain their operations while seeking bankruptcy protection.
Investing in Secured or Unsecured Bonds
Generally, secured bonds are considered safer investments than unsecured bonds. If the company begins to struggle financially, the asset used as collateral can be sold to help the company meet its financial obligations. Therefore, investors are willing to accept a lower rate of interest on secured bonds.
Unsecured bonds will typically pay a higher rate of interest than secured bonds. If a company liquidates its assets in a bankruptcy proceeding, the holders of unsecured debt have no real claim to money owed. There isn't an asset the bankruptcy trustee can sell to help repay these bondholders.
While secured debt can provide the investor with a greater sense of safety, it should not be the ultimate measure of protection against default.
Bond Ratings
Bond ratings were specifically developed to help investors understand the relative risk involved with the purchase of bonds. These ratings are an independent entity's assessment of the borrower's ability to meet all of their financial commitments. Currently, there are three credit agencies that set the standards for bond quality ratings: Moody's, Standard and Poor's, and Fitch Ratings.
Each agency uses roughly ten different credit ratings, or grades, that range from Investment Grade to In Default. A bond credit rating is perhaps the single most important factor used to determine the appropriate interest rate, or yield.
Bond Features
In addition to the ratings assigned to a bond, investors should also consider the features present in each bond. For example, bonds can be callable, which allow the issuer to repay the bond's face amount before its maturity date. Zero coupon bonds do not pay periodic interest; rather they are sold at a discount to face value.
The point being made here is the investor should consider multiple factors when determining if a purchase will suit their needs. For example, a secured bond that is of junk quality is a much riskier investment than an unsecured bond that is considered investment grade. While high-quality zero coupon bonds are useless to investors seeking a periodic stream of income.
About the Author - Secured and Unsecured Bonds
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