Key Takeaways
- A secured bond is backed by collateral, giving investors’ rights to an asset if the issuer defaults.
- Types of secured bonds include mortgage bonds and equipment trust certificates.
- They are generally safer than unsecured bonds but may offer lower yields.
- Risks include collateral devaluation, unsaleable assets, or legal challenges to asset claims.
- Municipalities often issue secured bonds backed by anticipated project revenue.
What Is a Secured Bond?
A secured bond is a type of investment in which a loan is backed by collateral. This collateral is an asset owned by the issuer, providing security to the investors. Secured bonds may also be secured with a revenue stream that comes from the project that the bond issue was used to finance. If the bond issuer defaults, the collateral is transferred to the investors, reducing their risk.
Secured bonds are foundational in fixed income investments due to this added protection, making them attractive options for risk-averse investors. Common types of secured bonds include mortgage bonds and equipment trust certificates, often used by utility companies and municipalities for project finance. We’ll explore the workings, types, and benefits of secured bonds to help you make informed investment decisions.
How Secured Bonds Work
Secured bonds are seen as less risky than unsecured bonds because investors in them are at least partially compensated for their investment in the event of default by the issuer.
Types of secured bonds include collateral trust bonds, mortgage bonds and equipment trust certificates. They may be collateralized by assets such as property, equipment, or an income stream.
For example, mortgage-backed securities (MBS) are backed by the titles to the borrowers’ homes and by the income stream from mortgage payments. If the issuer does not make timely interest and principal payments, investors have rights to the underlying assets as repayment.
The risk of loss occurs if the collateral falls in value or is unsaleable by the time it is in the possession of the bond investors, or if legal challenges delay liquidation of the assets.
Municipal Secured Bonds: Insights and Examples
Municipalities typically issue secured bonds that are backed by the revenue that is anticipated from a specific project. They may also issue unsecured bonds, known as general obligation bonds, that are backed by the city or town’s taxing power.
Important
Secured bonds are not risk-free. There is the risk that the collateral will fall in value or be unsaleable when it is transferred to the investors.
In some cases, investors’ claims to collateral are challenged in the courts. There are costs and delays inherent in responding to legal challenges. In this and other cases, investors may lose some of their principal investment.
Exploring First Mortgage Bonds
Companies that have significant real estate and holdings or other assets may issue mortgage bonds using those assets as collateral.
Many utility companies are able to secure loans at a lower cost by using their substantial land, power plants, and equipment as collateral. Because the bonds carry less risk, they offer lower interest rates than unsecured bonds. Their bondholders have the first claim to the underlying property in case the company does not make principal and interest payments as scheduled.
A first mortgage bond contains a first mortgage on at least one of the issuer’s properties. That gives the bondholder the first claim on the underlying assets in case of default.
If the issuer has enough cash, rather than selling the underlying assets it may use the cash to pay off the first mortgage bondholders before others.
Understanding Equipment Trust Certificates
An equipment trust certificate is backed by an asset that is easily transported or sold. The title to the equipment is held by a trust.
Trust certificates as generally issued to provide the cash to purchase equipment or finance operations. The company makes its scheduled payments to the trust, which pays the principal and interest income to investors. When the debt is repaid, the asset’s ownership transfers from the trust back to the company.