Secured bonds come with a pledge of collateral. Unsecured bonds are issued by entities with higher credit ratings and do not offer collateral.
Investors can analyze both types of bonds for the perceived risks. Both types of bonds carry a varying degree of default risk. Thus, the return on investment will also be different.
Let us discuss the key features of secured and unsecured bonds and analyze the key differences between both.
What is Secured Bonds?
Secured bonds are backed by assets as collateral. These are the debt instruments that have that backing in the form of a pledge.
Bond issuers often use fixed or long-term assets to raise debt financing from the market. Bonds are a typical source to raise capital from the market.
A secured bond can be backed by a physical and tangible asset. It can also be backed by intangible assets such as the revenue stream or a legal contract.
If the bond issuer defaults, the collateralized assets are transferred to the investors. However, these bonds do carry some degree of risk.
Some of the common types of secured bonds include:
- Mortgage Bonds: These bonds are backed by real estate properties. Thus, these bonds come with tangible assets pledged as collateral.
- Equipment Trust Certificates (ETCs): These bonds are issued to raise capital for equipment purchases. The ownership lies with the bondholder until full payment.
- Secured Bonds by Municipalities: These bonds are issued by municipalities often for specific projects. These bonds come with revenue backing as collateral.
Characteristics of Secured Bonds
Secured bonds are issued by municipalities, real estate trusts, and corporations. Usually, these entities possess large tangible assets. They pledge these assets to raise capital from the market.
Secured bonds backed by large and tangible assets are perceived as less risky. In case the bond issuer defaults, the bondholders have a right to claim the assets. However, these bonds are not totally risk-free.
A key characteristic of secured bonds is their low coupon rate on offer. Since the investment is perceived as almost risk-free, investors receive a lower return on investment.
Although secured bonds are often backed by physical assets, they may come with intangible asset backing as well. For example, municipality bonds may have the project revenue stream as a pledge for collateral instead of any tangible asset.
Secured bonds can come with or without recourse. A recourse bond is more favorable to the bond issuer while a non-recourse bond favors the investors.
What is Unsecured Bonds?
As the name suggests, unsecured bonds do not have any collateral backing. These bonds do not have a pledge of assets to cover the default risk of the borrower.
Unsecured bonds are often issued by governments, trusts, and large corporations. These bonds are issued solely on the backing of the trustworthiness of the issuer. For example, bonds issued by the US government will be backed by strong trustworthiness rather than any physical assets.
Unsecured bonds are generally riskier in nature. These bonds can be issued by several types of entities. Bond issuers compensate investors with higher coupon payments for higher perceived risk.
Characteristics of Unsecured Bonds
Unsecured bonds do not have any assets as collateral. These bonds are issued by corporations, government entities, and trusts that enjoy a high reputation and trustworthiness.
As compared to secured bonds, these bonds are riskier and offer higher interest rates. However, as secured bonds are not totally risk-free, unsecured bonds are not always too risky.
Many unsecured bonds come with a long maturity period. Governments and corporations issue unsecured bonds for the long-term, often around 20 or 30 years. Many of these bonds are redeemable and come with a call feature.
Secured Vs Unsecured Bonds
Secured and unsecured bonds are used for the same purposes by the issuers and investors. They differ in many ways from their perceived risk, return on investment, and other features.
Let us discuss a few key features that distinguish secured and unsecured bonds from investors’ and issuers’ perspectives.
There are no thumb rules on deciding whether a secured or unsecured bond will be issued by a particular entity.
Generally, secured bonds are issued by corporations, municipalities, equipment trusts, and real estate trusts to raise funds.
Contrarily, unsecured bonds are issued by entities that do not require physical assets to pledge as collateral. These entities include government institutions, corporations, and large companies.
From an investor’s perspective, both types of bonds carry a similar degree of risk. Capital financing through bonds is an expensive route that small to medium-sized businesses cannot afford.
2. Guarantee and Security
Secured bonds come with a guarantee of collateral. In the case of default of the issuer, investors can claim assets pledged as collateral.
Contrarily, unsecured bonds do not offer any guarantee in terms of pledged assets. Their sole guarantee is the reputation of the bond issuer.
It means secured bonds offer a higher degree of security to investors as compared to unsecured bonds. However, unsecured bonds are often issued by financially stable and strong entities.
Thus, the security of the bonds will also depend on the bond issuer somewhat.
3. Default Risk
Apparently, unsecured bonds carry higher default risk. However, these bonds are issued by government entities, municipalities, and large corporations.
It means the chances of default of these entities are thin. Thus, unsecured bonds do not carry any exaggerated default risk if issued by a financially strong entity.
Similarly, secured bonds do carry a default risk up to some extent as well. Unlike the common notion, secured bonds also carry some risks including default risk.
If the secured bonds come with a non-recourse clause, it will benefit investors. It is for the fact that a non-recourse means investors can claim other than pledged assets owned by the bond issuer. While a recourse does not allow investors to lay claim on assets other than pledged for the issued bond.
4. Coupon Rate
The coupon rate offered on secured and unsecured bonds depends on several factors combined. Market interest rates (Interbank lending rates) play a key role in deciding the coupon rate on offer for bonds.
The risk carried by these bonds also plays a key role. Generally, unsecured bonds are perceived riskier; hence they offer higher coupon rates. Although some unsecured bonds such as T-bills offer lower coupon rates.
Similarly, some secured bonds may offer higher coupon rates. Other features such as a call feature, coupon frequency, convertibility feature, etc. also play an important part in deciding the final coupon rate of the bond.
5. Priority in Bankruptcy of the Issuer
Secured bonds get the higher rank in the priority list in case of liquidation. If the bond issuer applies for bankruptcy, investors of secured debt have the first claim on the pledged assets.
After senior secured debt, the senior unsecured debt is prioritized. These bonds are unsecured but issued by the same bond issuers with a high credit rating.
After that, subordinated and junior debt is listed. It means unsecured junior bonds are listed at the bottom.
6. Investment Suitability
Investors would look to generate a higher return on investment. Generally, unsecured bonds offer a higher coupon rate than secured bonds. However, it is not a rule of thumb either.
An investor should look collectively at different features on offer. A secured bond can offer higher coupon rates. Else, it will be offered at a discounted price on the par value of the bond. Either way, it will benefit the investor.
Collectively, an investor must assess the risk-reward relationship on offer by each bond. A bond with a higher perceived risk will offer a higher return on investment. Conversely, even a secured bond may offer a lower rate of return.
7. Secured Bonds with and Without Recourse
Although secured bonds carry a lower degree of default risk, they are not always risk-free investments. A key feature to look for is the with or without recourse clause attached to a bond.
A bond without recourse benefits the bond issuer. In case of default, the investors can only claim the pledged assets against the secured bond contract. Even if the investors cannot fully settle the claim, they cannot claim other assets owned by the bond issuer.
Similarly, a bond with recourse means the investors can claim other than the pledged assets as well. Thus, a bond with recourse will favor investors as compared to non-recourse debt.
8. Bonds Guaranteed and Insured by Third-Parties
These are special types of bonds that are insured or guaranteed by a third party against the default risk. Thus, the bond issuer does not need to pledge any assets.
Bond insurers can be a financial entity, a government institution, or a corporation for its group entity. The purpose is to secure debt financing through the credit rating backing of a third party.
Although these bonds are also not totally risk-free, they are less risky than unsecured bonds.
Secured and unsecured bonds come with distinctive features—the most prominent being the level of security and perceived risk on offer.
Several factors contribute to deciding the risk profile of a bond including the credit rating, interest rates, maturity period, and collateral. From an investor’s perspective, the risk-reward relationship would be the deciding factor.