When you hear secured bonds, you must be thinking that such loans or bonds must be safe or the payments of secured loans or secured bonds will be secured by some kind of security.
Well, that is the most straightforward understanding of what a secured bond can mean. Before delving into the intricacies of Secured Bonds, let’s first understand how bonds work.
Bonds are debt instruments that are issued by governments and private/public corporations to borrow funds from the general public and repay them at a later date, called the “maturity date.” When you lend money through a bond, you become entitled to receive periodic coupon payments (interest earned).
But how can you trust the bond-issuing entity with your hard-earned money? The trust in the repayment of the bond comes from two things: one is the collateral if any, that the issuing entity has set aside for funds borrowed. The other is its creditworthiness, which is examined by credit rating agencies. Secured bonds are those bonds that are backed by some form of collateral. Therefore, even if the issuing company defaults, the amount you lent (or at least a part of it) can be recovered by liquidating the collateral.
Let’s dive deep into the term, ‘secured bonds’ and understand how they work, their types and other important features.
Secured Bond: Meaning and Example
If a bond is backed by assets, it is called a “secured bond.” The assets here are the collateral(s), which can be used to pay back your principal or coupon amount fully or partially in case the company defaults.
The assets used to back a secured bond can be physical assets such as manufacturing plants, property, and equipment or liquid financial assets such as stocks. Since the issuer’s assets secure the bonds, these debt instruments are relatively safer than equity instruments.
Understanding Secured Bonds with an Example
Let’s say the government issues a bond to raise funds for the construction of a road. The bond is secured by the future revenue that will be earned through toll collection. These are a type of revenue bond.
Similarly, corporations demarcate their real estate property as collateral to secure first mortgage bonds. If the issuer defaults, they can sell the property to make up for the lost principal or coupon payments.
For instance, UGro Capital raised secured bonds worth Rs. 50 crores backed by nearly Rs. 62.5 crores of loans. The loans here are assets serving as collateral.
However, the risk of being backed by collateral is that if the value of the collateral asset falls below the investment amount, the bondholders make losses.
Advantages of Secured Bonds
Here are a few reasons why you should consider Bonds investment:
- One of the major advantages of investing in a secured bond is that they are relatively safer than equity and provide security against failure to repay the invested amount.
- Secured bonds offer regular fixed income to the investor, although the interest rates can be lower, as compared to equity.
- Since secured bonds are asset-backed and offer regular income, they provide investors with a steady cash flow to manage their cash flow more efficiently.
- Even newer companies and municipalities can raise funds through secured bonds despite not having a lot of credibility in the market.
- Issuing secured bonds saves the cost of funds for the company as they have to pay lower coupon rates on them as compared to unsecured bonds.
Risks Involved in Investing in a Secured Bond
These bonds involve specific risks that you must know of before investing in them and in case of borrower default, the money would be realised post the bankruptcy proceedings of the entity (this process can take time).
- You may lose your money if the collateral becomes unsaleable or its value drops in the market;
- If the issuer of the bond offers collateral with the intention of fraud, you may lose your money in such a case.
- The interest rate fluctuations in the economy will affect the value of the bond in the secondary market and it can change if someone is looking to sell it before maturity and if someone holds the bonds till maturity, the coupon and principal will be paid;
- These bonds come with a lock-in period, and you might not be able to redeem them. In such a case, you can face a liquidity risk where your money will be stuck when you need it.
Also, note that the secondary market for these bonds is limited so one should invest with the intention of holding till maturity.
Secured vs. Unsecured Bonds
Unsecured bonds are those bonds that are not backed by any asset. Clearly, they are riskier as compared to secured bonds. In the case of default, secured bonds ensure that you can at least partially recover your losses, while this is not the case of unsecured bonds. The only source of credibility for the bond to the investor is the reputation and creditworthiness of the investor. As a result, the returns on unsecured bonds are higher than those on secured bonds.
Secured bonds are starting to become popular in the debt market due to the security they offer, and the interest rates are also high. You can add secured bonds to diversify your portfolio.
However, your risk appetite, financial goals, and interests are the major deciding factors before investing in any security.
What is the difference between a secured bond and an unsecured bond?
A secured bond is backed by assets, which could be moveable or immovable property or future revenue streams. On the other hand, an unsecured bond is not backed by any collateral. Therefore, they are compensated with higher coupon rates as compared to secured bonds. In the event of default, the secured bondholders are paid first by selling the assets backing the bond. Unsecured bondholders are paid after them by using the remaining general assets of the company.
What assets are secured bonds backed by?
Secured bonds can be backed by physical assets of the issuing company such as real estate, manufacturing plants, equipment, etc. or expected future revenue streams of the company such as loans that the company has given out in the past. Secured bonds backed by physical assets are usually considered more secure as there is always a risk associated with the realisation of future revenue streams.
Why are secured bonds better?
There can not be a universal answer to which type of bonds are better. While secured bonds offer more protection to bondholders in case of default, the coupon rate (interest rate) on unsecured bonds is usually higher to compensate for the high risk. It depends on your risk appetite and financial goals as to which of the secured or unsecured bonds is better for you. In the case of insolvency, bondholders are paid before the debenture holders.
How can I buy senior secured bonds?
You can buy senior secured bonds in India through your Demat account with a securities broker.
Krishna is an investment professional with a demonstrated history of working in Debt Capital Markets. He has completed his B.E. (Hons) in Computer Science Engineering from BITS Pilani and MBA (Finance) from JBIMS, Mumbai. He is currently working as Investments Principal at Wint Wealth. Previously he worked at Kotak Mahindra Bank at their DCM desk and Northern Arc Capital at their Structured Finance desk.