Bonds: Secured vs. Unsecured Bonds
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.
Secured Bonds:
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.
If the issuer defaults, the investors may take
possession of the collateral. A mortgage-backed bond is an example of a
secured security, since the underlying mortgages can be foreclosed and the
properties sold to recover some or all of the amount of the bond. Holders of
secured bonds are at the top of the pecking order if an issuer misses an
interest payment or defaults on repayment of principal. Some major types of
secured bonds are listed below.
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Mortgage bonds - These 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.
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Revenue bonds (or limited obligation bonds)
- To finance projects such as bridges, hospitals and power plants,
municipalities sell revenue bonds. The revenue generated by those projects
secures them.
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Collateral trust bonds - A bond that is secured by the securities
portfolio containing stocks and bonds
of the
companies that are controlled by the issuing company.
A third-party trustee holds the securities.
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Equipment trust certificates - These
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."
Instead, the issuer promises that they will be repaid. This promise is
frequently called "full faith and credit."
Federal government bonds and most bonds issued by large corporations are, in fact,
debentures, which are backed by the corporation's reputation rather than
secured by any collateral, such as the company's buildings or its inventory.
Although debentures sound riskier than secured bonds, they generally aren't,
since they are usually issued by well-established companies with good credit
ratings.
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.
If a company issuing debentures liquidates, it
pays holders of secured bonds first, then debenture-holders, and then owners
of subordinated debentures. Below are some explanations for the most popular
types of unsecured bonds.
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Treasury 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.
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Convertible bonds - These are corporate bonds that you can convert
into common stock of the company that issues them rather than redeeming
them for cash when they mature. The details the conversion, such as the
price of the stock, are set when the bonds are issued. These bonds have
a double appeal for investors concerned about volatility and high stock
prices: Their prices go up if stock prices go up but usually drop less
than the underlying stock price if that price should fall. And while
convertible bonds typically provide lower yields than regular bonds,
they provide higher yields than the underlying stock. Since convertible
bonds are closely linked to the price of the stock, they tend to be more
closely in sync with the stock market than the bond market.
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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.
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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.
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U.S. Savings Bonds: An American Institution.
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