Secured vs. Unsecured Bonds
Bonds, which represent the seller’s pledge to make scheduled interest payments and principal repayments to the buyer, can be either “secured” or “unsecured.” Each of these bond types presents different opportunities and challenges for the buyer.
Types of Bonds
Secured Bonds: They are those that are collateralized by an asset – for instance, property, equipment (as is commonly the case for bonds issued by airlines, railroads and transportation companies), or by another income stream. Mortgage-backed securities (MBS) are an example of a single bond-type secured by both the physical assets of the borrowers — the titles to the borrowers' residences— and by the income stream from the borrowers' mortgage payments.
It means that in the event that the issuer “defaults” – or fails to make interest and principal payments – the investors have a claim on the issuer’s assets that will enable them to get their money back. At least, that's the general intent of collateralizing a bond. This claim on the borrower's assets, however, may sometimes be challenged, or it may be that an asset sale will not make the bond's investors whole. In both cases, the likelihood is that after some delay — which may range from weeks to years — the bondholders will have only a portion of their investment returned, perhaps only after the deduction of legal fees that can be considerable.
Typically, secured bonds are issued by corporations and municipalities. The majority of corporate bonds, however, are unsecured. In the case of municipals, unsecured bonds are often referred to as general obligation bonds, since they are backed by the municipality’s broad taxing power. In contrast, “revenue” bonds, which are bonds backed by the revenue expected to be generated by a specific project, and which are therefore considered secured bonds.
Unsecured Bonds: They are not secured by a specific asset, but rather by "the full faith and credit" of the issuer. In other words, the investor has the issuer’s promise to repay but has no claim on specific collateral.
This doesn’t necessarily have to be a bad thing: keep in mind that U.S. Treasuries — generally regarded as the lowest risk investment in the world when it comes to the possibility of default — are all unsecured bonds.
Even owners of unsecured do have a claim on the assets of the defaulted issuer, but only after investors whose securities are higher in the “capital structure” are paid first. If for example, Widget Corp issued unsecured bonds and secured bonds and later went into bankruptcy, the holders of the secured bonds will be paid first.
Debt, such as unsecured bond debt, is said to be “subordinated,” or junior, to secured debt.
Risk and Return Characteristics
Generalizations regarding the risks and return characteristics of bond debt are subject to many exceptions. For example, although one might suppose that secured debt represents a lower risk to bondholders than unsecured debt, in practice the opposite is often true. Investors buy uncollateralized debt because of the issuer's reputation and economic strength. In other words, it's because the risk of default is sufficiently remote that bond investors are willing to accept the bond without collateralization. In the case of Treasury bonds, for instance, none of which are secured by anything more than the reputation of the U.S. government, the issuer has never failed to make a scheduled interest payment or failed to return the full principal upon maturity in more than 200 years.
With secured bonds — not all, but many— the reason that the bonds are secured is that the issuer is aware there's little interest from investors in buying its unsecured bonds — in other words, the issuer's reputation and perceived economic strength don't justify an investor's purchase of the bond without collateralization.
In both instances, unsecured bonds by economically strong issuers and secured bonds by weaker issuers, the unsecured bond may have a lower interest rate at issuance than the secured bond. Lower-rated corporate bonds, i. e., junk bonds, always have high-interest rate schedules at issuance.
But, again, these kinds of generalizations are only valid to a point. Some very strong institutions traditionally offer secured debt -- among them quasi-governmental energy producers --, and in such instances, the offered interest rate will be low for the same reason that unsecured debt may offer a relatively low-interest rate.
In sum, the best generalizations regarding the risk and return characteristics of secured and unsecured bonds are that
- Debt perceived to be risky — to represent a plausible risk of default — will always offer relatively high-interest rates and bonds whether secured or not.
- Debt issued by governments and corporations with a reputation for economic strength will offer relatively low interest rates.