Course 106: The Role of Collateral
Collateral Used to Secure Bonds
In this course
1 Introduction
2 Collateral
3 Collateral Used to Secure Bonds
4 Collateral Reduces Default Risk
5 Collateralized Securities May Offer Lower Rates
6 Advantage of Collateral

In order to secure their investment offerings, some companies use portfolios of securities as collateral. A portfolio of securities is a collection of investments in the stocks, bonds, Treasury notes, etc., of other companies.

One type of investment that uses securities as collateral is a repurchase agreement. In a repurchase agreement, one party, the buyer, is lending money and receiving securities as collateral. The other party, the seller, is borrowing money and selling the securities as collateral for the loan. The seller commits to buying the securities back from the temporary buyer at an agreed-upon price (including interest) at a specific future date. If the seller defaults on the agreement to buy back the securities, the buyer can sell the securities on the secondary market.

Collateral trust bonds also use securities to secure their debts. The securities pledged by the bond issuer are held by a trustee.

Certain types of investments pledge equipment to ease the fears of their investors. Equipment trust certificates are bonds secured by specific types of equipment such as railroad boxcars or airline equipment. These types of collateralized securities are popular with transportation companies. For example, suppose a railway company wishes to finance the purchase of new boxcars. The legal title to the cars is held by a trustee, who leases the cars to the railroad. The trustee then issues equipment trust certificates in an amount almost equal to the cars' purchase prices. The trustee collects lease money from the railroad to pay the interest on the certificates. When the certificates mature, the trustee sells the equipment to the railroad and cancels the lease.

One of the most common forms of collateral is mortgaged property such as buildings and real estate. Mortgage-backed bonds are secured by a pool of home mortgages and are typically issued by federal agencies such as Ginnie Mae. Collateralized mortgage obligations (CMOs) are a special type of mortgage-backed bond that divides its investors into different classes depending on the length of their investment.

When a government wishes to finance projects such as the building of roads or bridges, it can issue revenue municipal bonds. With a revenue bond, the bond issuer pledges the revenue of the project it finances. However, revenue bonds only pay back the bonds' principal and interest if enough revenue is produced by the financed project.

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