Secured vs. Unsecured Bonds
Bonds—which represent the issuer’s pledge to make scheduled interest payments and principal repayments to the buyer—can be either secured or unsecured, and each of these bond types present different opportunities and challenges for the buyer.
Secured bonds are those that are collateralized by an asset, such as property, equipment (especially for 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, like the titles to the borrowers' residences, and by the income stream from the borrowers' mortgage payments.
The purpose of collateralizing a bond is so if the issuer defaults and fails to make interest or principal payments, the investors have a claim on the issuer’s assets that will enable them to get their money back. This claim on the borrower's assets, however, may sometimes be challenged, or an asset sale may not result in enough to pay back investors fully. 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.
Typically, secured bonds are issued by corporations and municipalities. Many corporate bonds, however, are unsecured. In the case of municipals, unsecured bonds are often referred to as general obligation bonds, since the municipality’s broad taxing power backs them. In contrast, “revenue” bonds, which are bonds backed by the revenue expected to be generated by a specific project, are considered secured bonds.
Unsecured bonds 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, though. U.S. Treasuries, which are generally regarded as the lowest risk investment in the world when it comes to the possibility of default, are all unsecured bonds.
Owners of unsecured bonds 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. For example, if Widget Corp issued both unsecured and secured bonds, and later went into bankruptcy, the holders of the secured bonds will be paid first. Unsecured debt is subordinated 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 the case of Treasury bonds—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 return the full principal upon maturity in more than 200 years. With most secured bonds, 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 like junk bonds always have high-interest rate schedules at issuance. These kinds of generalizations are only valid to a point, though. Some very strong institutions traditionally offer secured debt, like 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.
The Bottom Line
The best generalizations regarding the risk and return characteristics of secured and unsecured bonds are that debt perceived to be risky will always offer relatively high-interest rates, and debt issued by governments and corporations with a reputation for economic strength will offer relatively low interest rates. In both cases, the truism applies: Risks and returns are correlated. Especially in bond markets where risk and yield go hand-in-hand.