A bond is a debt security commonly issued by government agencies as well as large corporations. Regardless of the issuing entity, all securities fall into two overarching categories: secured and unsecured bonds. Investors thinking about buying bonds need to understand the risks, rewards, advantages, and disadvantages of these securities.
In this article, 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 security. We'll then talk about their pros and cons; finishing up with a discussion of the factors to consider before purchasing a bond.
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.
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. These bonds could be secured by the toll charges collected from motorists traveling across the bridge. In this example, the bond would be secured by a future revenue stream (cash). This type of bond is oftentimes referred to as a revenue bond.
Companies can also purchase real estate or other mortgageable property. When doing so, the company may decide to use the real estate as collateral. This is accomplished through a mortgage bond. If the company defaults on this security, the bondholders can collect a share of the money they're owed by foreclosing on the property.
This category 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 debt.
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.
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 large corporations, and the payment of interest is contingent upon sufficient earnings. Also known as an adjustment bond, this last type of security is frequently issued by companies attempting to maintain their operations while seeking bankruptcy protection.
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.
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 were specifically developed to help investors understand the relative risk involved with the purchase of these securities. 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 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 company's credit rating is perhaps the single most important factor used to determine the appropriate interest rate, or yield.
In addition to the ratings assigned to a bond, investors should also consider the features offered. 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.
Before making a purchase decision, it's important for an investor to consider all of the above factors. 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.
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