Collateral Trust Bond: Definition and How It Works

A collateral trust bond is secured by the issuer’s security instruments held with a trustee. These securities can include stocks, bonds, and notes to name a few. The issuer grants a lien to the investor in a collateral trust bond.

Collateral trust bonds are secured financial instruments as they come with collateral. The value of financial securities pledged must be assessed at market fair value to match the bond value. Investors hold the rights to pledged financial securities in case the issuer defaults.

Definition

A collateral trust bond is backed by financial securities owned by the bond issuer. The financial securities can include stocks, notes, bonds, and financial instruments owned by the issuer. The trustee keeps the financial securities without voting rights.

The trustee holds the financial securities on behalf of the bondholder. It acts as a financial guarantor. In the case of default, the bondholder receives the rights to sell the financial securities.

How Does Collateral Trust Bond Works?

Large companies and corporations issue bonds to raise capital. Bonds can be issued for short-term or long-term financing needs. Debentures are issued without collateral, hence costs higher. Companies can issue collateral trust bonds backed by collateral to reduce the costs of borrowings.

Companies with stockholdings in subsidiaries often issue collateral trust bonds. These companies do not need to pledge physical assets as collateral. The financial securities including stocks and bonds act as collateral. Thus, these companies can utilize the basket of financial securities to obtain further capital from the market.

The collateralized financial securities are held with a trustee. The trustee does not hold the voting rights that come with the stocks owned by the bond issuer. However, if the bond issuer defaults, the bondholder keeps the rights to sell these securities to cover losses. Since the pledged assets are marketable securities, the collateral trust bonds are considered safer than other types of bonds.

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Since these bonds come with pledged financial securities as collateral, these are considered safer investments. However, the security feature reduces the return on investment. Contrarily, the security feature benefits the issuer by reducing the costs of borrowings. Investors can take the lower yield on collateral trust bonds as they receive guaranteed returns and collateral backing. Similarly, the bond issuers do not need to pledge any physical assets such as property or equipment to raise capital financing. Thus, it creates a win-win situation for both the borrowers and investors.

Special Considerations with Collateral Trust Bonds

The biggest advantage with collateral trust bonds is their backing by collateral. Financial securities owned by the issuer act as collateral in this arrangement. These financial securities include stocks, bonds, and notes. The market value of these financial securities must match the bond value at the time of issuing the bond.

The value of these financial securities is regularly assessed since the market value of financial securities fluctuates over time. If the combined market value of pledged financial securities decreases, the bond issuer may need to pledge cash or other securities with the trustee.

In the case of bond issuer default, the secured bondholders have the first right to pledged assets. Secured bondholders have priority over unsecured bondholders and stockholders.

Advantages of Collateral Trust Bonds

These bonds offer great benefits to bond issuers and investors alike.

  • These bonds are backed by financial securities that act as collateral.
  • Secured bonds reduce the costs of borrowings for issuers.
  • These bonds reduce the risk of default for investors.
  • The investors hold the first rights to pledged collateral in case of bond issuer’s bankruptcy.
  • Bond issuers keep the voting rights after transferring the stocks to a trustee.
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Disadvantages of Collateral Trust Bonds

Collateral trust bonds also offer some limitations to both parties in the arrangement.

  • Investors have to settle for lower returns on investments as collateral feature reduces the yield on secured bonds.
  • Bond issuers may need to pledge cash or other financial securities to match the depleting combined market value of financial securities.
  • In the case of bankruptcy, the voting rights of the bond issuer are transferred to the trustee that can sell these financial securities to cover losses of investors.

Conclusion

Collateral trust bonds are secured bonds issued by large companies that are backed by financial securities held by the issuer. The financial securities are held by a trustee during the arrangement. These secured bonds offer a safer but lower yield to investors. The financial securities pledged as collateral must match the market value of the issued bond amount.

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