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Course 107
Secured and Unsecured Bonds

Introduction

Bonds are issued as evidence of a loan. They may be backed with collateral or just the good faith and credit of the borrower. As an educated investor, you need to know the advantages and risks of bonds and whether they are secured or unsecured.

Bonds may be secured by collateral, which is the money or physical assets that a bond issuer (borrower) must give to investors if the bond defaults. Securing bonds ensures that capital will be available to pay the principal on a bond. Corporate bonds and municipal bonds may be secured or unsecured.

Federal government bonds, however, are unsecured and only backed by the good faith and credit of Uncle Sam.

Identifying Secured Bonds

Mortgage bonds are secured corporate bonds that are backed primarily by real estate, although they may include other corporate assets as well. They may cover all mortgageable property or just specific pieces.

Because mortgage bond collateral provides a clear claim on a company's assets, mortgage bonds are considered high-grade and safe from default. A trustee acting on behalf of bondholders holds the collateral; if the bond defaults, this trustee may foreclose for the bondholders.

Mortgage bonds may be either first mortgage bonds or junior mortgage bonds. Should an issuer have to liquidate, first mortgage bonds are paid off before juniors are.

To finance projects such as bridges, hospitals, and power plants, municipalities sell revenue bonds (or limited obligation bonds). The anticipated revenue generated by those projects is used to secure them.

Because they are backed with specific collateral, secured bonds are perceived as safer investments than unsecured bonds. Financial assets in the form of a securities portfolio containing stocks and bonds secure collateral trust bonds. A third-party trustee holds the securities.

Equipment trust certificates are backed by company equipment such as trucks, airplanes, railroad cars, etc. They are often issued by airlines and railroads that need to finance new purchases of equipment. The equipment bought may be the same equipment that is collateralized. A trustee for the bondholders keeps the title to the equipment. After all the bondholders have been repaid, the trustee then returns the title to the company.

Because they are backed with specific collateral, secured bonds are perceived as safer investments than unsecured bonds. Because they are perceived as safer, they typically pay lower interest rates. Secured bonds are favored by those who want to protect their investment capital.

Unsecured Bonds

Unsecured bonds, also called debentures, are not backed by equipment, revenue, or mortgages on real estate. Instead, the issuer promises that they will be repaid. This promise is frequently called "full faith and credit."

Why issue unsecured bonds? Some companies do not have enough assets to collateralize. Other companies are established and are therefore trusted to repay their debts. As for governments, they can raise taxes if they need to pay off bondholders.

Unsecured bonds naturally carry more risk than secured bonds; consequently, they usually pay higher interest rates than do secured bonds. If a company issuing debentures liquidates, it pays holders of secured bonds first, then debenture-holders, and then owners of subordinated debentures.

Types of Unsecured Bonds

Below are some common types of unsecured bonds.

To meet its financial needs, the U.S. government issues Treasury bonds. It issues them with the full faith and credit of the federal government. Because the U.S. government, of all issuers, has the best ability to repay, Treasury bonds are considered the safest from default and are very popular with investors.

General obligation bonds (GO bonds) are municipal bonds without backing. The creditworthiness of the issuing city or state is the only security they provide. GO bonds finance municipal operations. In the event that an issuer cannot repay its debts to bondholders, it may have to lay off employees, sell some assets, or raise taxes.

Income bonds are the bonds most junior of all. Their payments are made only after the issuer earns a certain amount of income. The issuer is not bound to make interest payments on a timely or regular basis if the minimum income amount is not earned. The investor is aware of the risks involved and may be willing to invest in these bonds if there is an attractive coupon rate or high yield-to-maturity.

Convertible bonds give the investor the option to convert the bonds into shares of common stock. The conditions, the time frame, and the price must all be set down at the time the bonds are issued.

Risk Tolerance

Bonds are favored by investors seeking current income and safety of principal. Some of these investors are willing to take more investment risk to get higher returns than others. Depending upon your risk tolerance, you may choose unsecured bonds if they offer high current income. Conversely, you may not be able to take much risk with your income. In this case, you would look for bonds that are backed by more than the good faith and credit of the issuers while seeking higher returns.

As a bond investor, you should become familiar with the different ways in which bonds are secured. This will help you choose bond investments best suited to your investment objectives and risk tolerance.

Quiz 107
There is only one correct answer to each question.

1 What type of collateral backs mortgage bonds?
a. Revenue
b. Real estate
c. Taxes
2 What secures revenue bonds?
a. Fees levied by municipalities
b. Taxes
c. Revenue generated by projects funded by the bonds
3 What is a debenture?
a. A bond without collateral behind it
b. A secured bond
c. A corporate equipment bond
4 What type of bond's interest and principal can be repaid by the U.S. government?
a. Treasury bond
b. General obligation bond
c. Municipal bond
5 Which type of unsecured bond can be exchanged for stock?
a. General obligation bond
b. Income bond
c. Convertible bond
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