In the world of business and investing, a lot of terms get bandied about casually. Some are well understood at a glance, but others require a deeper dive into the meaning. Secured bonds are one such term since a basic Google search will probably leave you confused and looking at a lot of pages for bail bonds. While technically, a bail bond is a form of a secured bond, that is not what it means in the context of investments. We’ll walk you through the details to clarify what makes this form of bond useful and how they differ from unsecured bonds.
How Does a Secured Bond Work
The shortest explanation for how a secured bond works is to say it comes with collateral. However, that falls far short of explaining the true versatility of this type of investment. Mortgages and liens may also back these bonds, making them relatively low risk compared to many investing options. When the issuer of a bond guarantees it with an asset or property which bondholders may take possession of in the case of issuer default, then it is considered secured. By offering these assurances, the bond issuer gets much-needed capital to complete a project. The bondholder gets a percentage of projected profits and collects a coupon rate, also known as a yield or nominal yield rate, semiannually for their money.
Because Secured bonds are guaranteed to have some form of repayment, these coupon rates are lower. Resultantly the bond issuer pays less to borrow money by issuing these bonds than they might if they borrowed in another way. In concept, everyone benefits from the arrangement. The lower interest payments also help lower the risk that issuers will fail to repay them. Additionally, secured bonds come with another condition that benefits the bondholders. While the issuer must repay all bonds regardless of their status, secured bonds must be prepared first. Only after that can unsecured bondholders hope for repayment.
As a result of this arrangement, all parties involved often benefit financially when the project goes well. On the other side of that coin, a project that falls through can result in a loss for everyone involved. Secured bondholders can end up with worthless property or assets, unsecured bondholders end up out of luck and with less money, and the issuer has the failed project along with the additional loss of the security assets. Moreover, if the issuer misses an interest payment, the holders of those bonds can collect their assets or property. However, these actions don’t always go smoothly. In fact, holders can end up tied up in court over the issue for a while and must accept the judgment whether it goes their way or not.
Also, similar to the secured bond, cash bonds offer a tangible guarantee. However, in this case, the guarantee is more often money. Likewise, the bond is not a contract for future repayment but rather the agreement to perform an action or service. Cash bonds are a variation of a secured bond. The most obvious example of this is the bail bond. Someone offers money as a guarantee that the person being released from jail will return to meet their court obligations. Failure to do so means the court doesn’t return the money, which can be a mere percentage of what is owed, leaving the issuer in debt. Most bail bonds cost only ten percent of the full sum to purchase, and if they are defaulted upon, the purchaser owes the balance.
What is an Unsecured Bond
Unsecured bonds or debentures are similar to secured bonds in many ways. The bondholders are loaning their money to the issuer, and they receive repayment if all goes well. In essence, the issuer promises to repay, but only their word backs the bond. The positive side of an unsecured bond is that they are most often issued by companies that are already financially secure, as a means to finance a new project without having to cut into profits or damage the budget of a company, for example. Unsecured bonds are a superb investment with low risk from a company that has a history of repayment. Furthermore, though unsecured bonds don’t get repaid until after secured bonds, there’s another benefit. By virtue of being unsecured, these bonds often have higher interest rates. Balancing risk and reward is up to the investor, but bonds offer a stark example of how those balances can work in practice.
Common Types of Secured Bonds
While there are plenty of variations on secured bonds, some of the more common types come in the form of equipment trust securities and mortgage bonds. Municipalities, utility companies, and businesses that transport goods often offer these bonds to obtain funds to expand or complete a project. Equipment trusts offer physical equipment to secure the loan of a bond. This can be anything of sufficient value. For example, a mining company with large digging vehicles worth substantial sums could offer equipment trusts. In exchange for funding a new dig site where they have a reasonable expectation of obtaining minerals or gems, they issue bonds.
Another example of an equipment bond might be a shipping company. By offering their ships as collateral, they could upgrade the fleet with new technology or add new ships to expand their routes. When a municipality offers bonds, the security can come from anticipated tax income. By expanding housing areas, enhancing or refurbishing business districts, and otherwise making efforts to raise property values and entice more people to the area, better income is likely. Investors can help finance a particular proposed project and reap the rewards as the area prospers. First mortgage bonds are commonly used by utility companies and other businesses with substantial real estate holdings. Utilities may also offer equipment, but power plants and land mortgages are a reliable method of assuring investors they will get their money’s worth.
While there is no such thing as a perfect investment, secured bonds are a less risky way to expand your portfolio. Some bonds can end up leaving investors with less than they initially put into a project. For example, the delivered property could become unsaleable, leaving you with nothing of true value. That said, it is still a relatively low-risk way to make a longer-term investment, and many find secured bonds help increase their wealth when appropriately researched.