Bonds are types of debt instruments that are issued by a large corporate or a government agency with the goal of raising funds of capital. Irrespective of whom it is issued by a bond falls into two broad categories. It is either secured or unsecured in nature. Knowing the difference between these two categories is essential for any investor. The risk to rewards ratio, as well as the pros and cons of putting money into either category is key research that should be undertaken by the investor.
Secured Bonds
If a bond that is issued is backed by an asset class, it is referred to as a ‘secured bond’. The type of assets backing this bond can be physical in the form of property, machinery, or plants, or they can be liquid in the form of stock. Secured bonds imply that in the event of the issuer defaulting upon its principal payment or coupon, the bondholders have the option to stake a claim on any of the assets that are backing up that bond.
As an example, suppose some hypothetical governmental agency decides to issue bonds so they can finance an infrastructure project that involves building a new highway. Bonds for the same can be secured in the form of the income that is generated by the collection of toll charges that all motorists who will be using that highway are liable to pay. With this type of secure structure of receiving payments, the future cash flows as well as revenue streams that make the said bond much more secure for any stakeholders. These types of secured bonds are called revenue bonds.
There are other types of secured bonds. Another example is when any corporate structure that wants to offer a collateral to its bondholders can dFo so by offering up real estate to them. These types of secured bonds are commonly called mortgage bonds. In case the corporate defaults on its principal payments or coupons, the bondholders can recover their payment dues by foreclosing on the property that serves as collateral.
Unsecured Bonds
The difference between secured vs unsecured bonds is the fact that the former is backed by assets while the latter is not. Unsecured bonds are also called debentures. In the scenario where the company that is issuing these bonds goes bankrupt and defaults on their payments to its shareholders, the repayment of the owed principal amount, as well as interest, is not guaranteed to the shareholders. This is because there is no asset or future revenue stream that can serve as collateral. Hence, the bond is ‘unsecured.’
As examples, unsecured bonds are seen in the form of notes, corporate bonds, treasury bills, and more. In general, any bond which is issued without being backed by an asset class is unsecured. This begs the question of why an investor would choose to invest in this type of structure. The short answer is that the investor relies on the credit-worthiness, faith, and credibility of the issuer when deciding whether or not to invest in the bond.
Secured vs Unsecured Bonds
The fundamental difference between secured vs unsecured bonds is the risk of repayment. As their name suggests to even a novel investor, secured bonds have a reputation of being the safer option to park one’s funds relative to unsecured bonds. In the scenario in which an issuer defaults on the payment of its coupons or principal amount to bondholders, secured bonds allow for one to recover their dues by liquidating the asset that is backing the bond. Due to this security, investors consider secured bonds good investments even at low rates of interest.
With unsecured bonds, investors no longer have any kind of security in the event of bankruptcy leading to issuer default. Investors choose unsecured bonds based on the credit-worthiness of the issuer. Assets as collateral offer a sense of security, but the primary intent of an issuer of an unsecured bond is to not default on their regular dues to bondholders at the time that the investment matures.
Conclusion
Whether one chooses to invest in a secured bond or an unsecured one, the decision should be formulated based on one’s financial goals. A junk bond can be considered a riskier investment but can also lead to substantial returns if taken with a trustworthy issuer. Estimate your investment horizon, formulate your risk profile, and plan as per your financial goals before investing in either bond.
FAQs
Since secured bonds are backed by a physical or liquid collateral, they guarantee that you will get your investment back (plus interest), even if the company defaults. No such guarantee is available with unsecured bonds since there is no collateral.
What's the difference between a secured and an unsecured bond? ›
There are two types of bonds – secured and unsecured. A secured bond means that you actually pay money or bail property to secure your release. An unsecured bond or surety bond means you sign a document that says you will pay a certain amount of money if the defendant breaks his/her bond conditions.
Are guaranteed bonds secured or unsecured? ›
Although guaranteed bonds come with the parent company's backing, they are still considered unsecured bonds. Essentially, the bond's success or failure is contingent on the parent company's ability to pay off the bond.
Are income bonds secured or unsecured? ›
An income bond is a type of debt security in which only the face value of the bond is promised to be paid to the investor, with any coupon payments paid only if the issuing company has enough earnings to pay for the coupon payment.
What are examples of secured and unsecured? ›
Mortgages and auto loans are types of secured loans. Unsecured loans don't require collateral but may charge a higher interest rate and have tighter credit requirements because of the added risk to the lender. Many personal loans and most credit cards are unsecured.
What is an example of an unsecured bond? ›
As examples, unsecured bonds are seen in the form of notes, corporate bonds, treasury bills, and more. In general, any bond which is issued without being backed by an asset class is unsecured.
What are the risks of a secured bond? ›
Secured Bonds Issued by Municipalities
They may also issue unsecured bonds, known as general obligation bonds, that are backed by the city or town's taxing power. Secured bonds are not risk-free. There is the risk that the collateral will fall in value or be unsaleable when it is transferred to the investors.
What are the main advantages to a secured vs unsecured? ›
Secured loans are backed by collateral and tend to have lower interest rates, higher borrowing limits and fewer restrictions than unsecured loans. Collateral for a secured loan might be the borrower's home or car, which the lender can claim if the borrower defaults on the loan.
How do secured bonds work? ›
With a secured bond, you pay cash or offer some type of property or real estate you own (or someone does this on your behalf) as collateral to assure that you will appear in court on your court date. If the amount is simply too much, a bail bondsman can post the bail on your behalf, for a fee.
Who benefits from secured bonds? ›
Secured bonds give investors a constant cash flow to manage their cash flow better because they are asset-backed and generate regular income. Even newer businesses and governments can raise money with secured bonds despite lacking market credibility.
Bonds carry the promise of their issuer to return the face value of the security to the holder at maturity; stocks have no such promise from their issuer. Most bonds pay investors a fixed rate of interest income that is also backed by a promise from the issuer.
Are senior secured bonds safe? ›
Senior secured bonds are a safer option than most bonds. These secured bonds will be backed by some kind of collateral or the company's assets, such as property, inventory, receivables, etc. At the time of liquidation, the bondholder of the senior secured bond will get priority over other investment holders.
What is better, a secured or unsecured bond? ›
A secure bond might be best if you are at risk of not appearing for arraignment, pretrial examination or trial; whereas an unsecured bond might be ideal if you feel that there is a low risk of not appearing in court.
Are unsecured bonds risky? ›
Unsecured bonds are highly risky because there is no specific asset to be seized upon default. Investors in unsecured bonds rely solely on the repayment capacity of the issuer. This risk can make unsecured bonds more appropriate for investors willing to take on higher risk for higher returns.
How do you tell if a bond is secured or unsecured? ›
Secured bonds have collateral backing, reducing risk for investors, while unsecured bonds rely on the creditworthiness of the issuer. Secured bonds may be backed by physical assets or income streams, such as mortgage bonds or revenue bonds.
What are secured bonds with examples? ›
Types of secured bonds include collateral trust bonds, mortgage bonds and equipment trust certificates. They may be collateralized by assets such as property, equipment, or an income stream.
Why are unsecured bonds risky? ›
Unsecured bonds are highly risky because there is no specific asset to be seized upon default. Investors in unsecured bonds rely solely on the repayment capacity of the issuer. This risk can make unsecured bonds more appropriate for investors willing to take on higher risk for higher returns.
Is unsecured or secured better? ›
Unsecured credit cards tend to come with better perks and rewards, lower fees and lower interest rates. Secured credit cards are usually for people with poor credit or no credit history, whereas unsecured credit cards are usually for people with good credit or better.
