What is a secured bond?

Usually, large organisations or governments can issue bonds to raise money instead of going to the bank for a regular lona. Although government bonds are considered safer investments than equity (usually), sometimes payments are also missed.

In circumstances when the debtor cannot pay the money back, an unsecured bond loses money. A secured bond, on the other hand, doesn’t.

In this article, we’re going to find out how secured bonds work and whether they’re actually any safer than regular bonds.

What are secured bonds?

Secured bonds, in essence, are just that – secured by another asset. This asset serves as collateral for the loan. If the bondholder defaults on the payment, this asset can be liquidated or sold to recover the principal.

These could be all sorts of assets:

• Inventory: These are goods or products held by the issuer, serving as a potential source of funds.
• Plant and equipment: Plant and equipment includes physical assets such as machinery, vehicles, and manufacturing facilities.
• Real estate: Properties owned by the issue.
• Accounts receivable: Outstanding debts owed to the issuer by its customers, representing a valuable source of collectible funds.
• Cash reserves: Cash reserves could be funds that are set aside for bond repayment in case of potential defaults.

Types of secured bonds include collateral trust bonds, mortgage bonds and equipment trust certificates.

• Secured bonds issued by the government – Usually, when the government finances projects with bonds, repayments are backed by the country’s tax power.
• First mortgage bonds – Companies with significant tangible assets can use them to secure cheap loans. Because these bonds carry less risk, they can be procured for less interest payments.
• Equipment Trust Certificates – This kind of bond is backed by assets that can be easily transported or sold.

For instance mortgage-backed securities are collateralised by the value of the underlying house, which means that if payments stop coming in, investors could recuperate their funds by selling the house.

Are secured bonds safer investments?

As you might have guessed already, secured bonds are considered safer than unsecured bonds. This is because for the former, investors are sure that at least part of their principal will be returned to them in case the issuer defaults.

This is also one of the reasons why secured bonds generally pay lower interest rates than unsecured bonds.

Pros and cons of secured bonds

Just like any other investment, secured bonds have both advantages and disadvantages:

Advantages

• Secured bonds are generally considered safer and offer at least partial protection for funds in case of default.
• Secured bonds also come with fixed payments for investors, even though they might have lower interest rates.
• Cash flows in secured bonds are more reliable since they are also backed by the company / government’s assets.
• Newer businesses which don’t have enough credibility yet can also issue secured bonds.
• From the corporation’s perspective, they have a lower cost of debt.

Disadvantages

• Although this goes with any other bond, secured bonds are also subject to market risks. In case interest rates go up, the bond value goes down in the secondary market.
• In the event of the default, the asset’s value will also play a part in deciding how much money can be repaid.
• When asset values get frozen in a recession, investor funds will still be locked even though the investment is technically secured.

Secured bonds vs. securities

Think of it like this: imagine borrowing money. 

If you pledge your car as collateral, the lender can take it if you can’t repay. That’s like a secured bond – the issuer puts up specific assets like buildings or equipment as backup. 

Now, the 2008 crisis was more like lending money based on promises and hopes, not real things. It was a bunch of loans bundled together, making it hard to tell who owed what and what you could actually sell if someone defaulted. 

Secured bonds, with their clear claims to real assets, offer a sturdier option, one that wouldn’t crumble in a financial storm like the one we saw back then.

In the end, the difference between bonds and securities is that bonds are generally safer than securities, which go through volatility every single day.

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