Bonds may be secured or unsecured. A secured bond is backed by collateral, meaning it has the money or physical assets that a bond issuer must give to investors if the bond defaults. Securing ensures that capital will be available to pay the principal on the bond. Corporate bonds and municipal bonds may be secured or unsecured. Federal government bonds, however, are unsecured.
After learning about some major types of secured bonds, we will discuss unsecured bonds, also called debentures. These bonds, instead of being secured with some kind of collateral, are backed by creditworthiness of the issuer.
This tutorial will discuss the following:
SECURED BONDS
Secured bonds are given names that reflect the type of collateral that backs them. Some major types of secured bonds are listed below.
Mortgage bonds are secured corporate bonds that are backed by real estate, although they may include equipment as well. They may cover all mortgageable property or just specific pieces. Because mortgage bond collateral provides a clear claim on a company's assets, mortgage bonds are considered high-grade and safe from default. A trustee acting on behalf of bondholders holds the collateral; if the bond defaults, this trustee may foreclose for the bondholders.
These bonds come in two types: first mortgage bonds and junior mortgage bonds. Should an issuer have to liquidate, first mortgage bonds are paid off before juniors are.
To finance projects such as bridges, hospitals and power plants, municipalities sell revenue bonds (or limited obligation bonds). The revenue generated by those projects secures them.
Financial assets in the form of a securities portfolio containing stocks and bonds secure collateral trust bonds. A third-party trustee holds the securities.
Equipment trust certificates are backed by company equipment. They are popular with airlines and railroads that need to finance new purchases of equipment. The equipment bought may be the same equipment that is collateralized. A trustee for the bondholders keeps the title to the equipment. After all the bondholders have been paid back, the trustee then returns the title to the company.
UNSECURED BONDS
Unsecured bonds, also called debentures, are not backed by equipment, revenue or mortgages on real estate. Instead, the issuer promises that they will be repaid. This promise is frequently called "full faith and credit."
Why are unsecured bonds issued? Some companies do not have enough assets to collateralize. Other companies are established and are therefore trusted to repay their debts. As for governments, they can raise taxes if they need to pay off bondholders. The federal government can print more money to meet its needs.
Unsecured bonds naturally carry more risk than secured bonds. However, they usually pay higher yields.
If a company issuing debentures liquidates, it pays holders of secured bonds first, then debenture-holders, and then owners of subordinated debentures.
Read below to learn about some popular unsecured bonds.
POPULAR TYPES OF UNSECURED BONDS
Here are some explanations for commonly issued unsecured bonds.
To meet its financial needs the U.S. government issues Treasury bonds. It issues them with the full faith and credit of the federal government. Because the U.S. government, of all issuers, has the best ability to repay, Treasury bonds are considered the safest from default and are very popular with investors. In the unlikely event of default, the government can print more money to repay its bonds.
General obligation bonds (GO bonds) are municipal bonds without backing. The creditworthiness of the issuing city or state is the only security they provide. GO bonds finance municipal operations. In the event that an issuer cannot repay its debts to bondholders, it may have to lay off employees, sell some assets or raise taxes.
Income bonds are the most junior of all bonds. Their payments are made only after the issuer earns a certain amount of income. The issuer is not bound to make interest payments on a regular basis if the minimum income amount is not earned. The investor is aware of the risks involved and may be willing to invest in these bonds if there is an attractive coupon rate or high yield to maturity.
Convertible bonds give the investor the option to convert the bond into shares of stock. The conditions, the time frame and the price must all be set in writing at the time the bond is issued.
The secured and unsecured bonds described here come in a variety of subtypes.
This concludes the tutorial on secured and unsecured bonds.
