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.
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.
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.
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.