What Is a Collateral Trust Bond?
A collateral trust bond is a bond that is secured by a financial asset—such as stock or other bonds—that is deposited and held by a trustee for the holders of the bond. The bond is perceived as a safer investment than an unsecured bond since the assets could be sold to pay the bondholder, if necessary.
A collateral trust bond is also called a collateral trust certificate or collateral trust note.
- A collateral trust bond is a type of secured bond, in which a corporation deposits stocks, bonds, or other securities with a trustee so as to back its bonds.
- The collateral has to have a market value at the time the bond is issued that is at least equal to the value of the bonds.
- The value of the collateral is periodically reassessed to make sure it still matches the value initially pledged.
- If over time, the value of the collateral falls below the agreed-upon minimum, the issuer has to put up additional securities or cash as collateral.
- This kind of bond is considered safer than an unsecured bond; however, the tradeoff with greater safety is a lower yield and therefore lower payout.
Understanding a Collateral Trust Bond
A corporate bond is a bond issued by a company to raise capital for its short-term debt obligations or long-term capital projects. In return for the loan provided by investors, the company pays periodic interest to bondholders and, upon maturity of the bonds, repays the principal investment.
Because companies prefer to issue debt with as low an interest rate as possible, they will seek out ways to reduce their cost of borrowing. One way to do this is by securing the bond issued with collateral through a security called a collateral trust bond.
If a corporation goes bankrupt or defaults on its debt, bondholders get paid back first, and holders of secured bonds get paid back before holders of unsecured bonds.
How a Collateral Trust Bond Works
A collateral trust bond is a bond with a claim against a security or basket of securities. These bonds are typically issued by holding companies since they usually have little to no real assets to use as collateral. Instead, holding companies have control over other companies, known as subsidiaries, by owning stock in each of the subsidiaries. A holding company will thus issue a collateral trust bond against securities of its subsidiary firms.
The collateralized securities pledged to secure the bond are transferred to a trustee to manage on behalf of the bondholders. Even though the trustee has custody of the pledged assets, the voting rights granted by these securities will remain with the corporate issuer.
For the securities to be eligible for collateral, their market values must be higher than the amount of the outstanding bonds by a certain percentage. The value of pledged securities will be regularly reevaluated and marked to market to reflect their market value. If during the life of the bond, the market value of the collateral falls below the stipulated minimum highlighted on the trust indenture, the issuer must pledge additional securities or cash as collateral.
Buying a secured bond such as a collateral trust bond is safer than buying an unsecured bond, but the extra safety has a price—a lower interest rate than what you would receive if you had bought a comparable unsecured bond.
Example of Collateral Trust Bond
If the issuing company were to default on the debt obligation, the debt holders would receive the securities held in trust, just like collateral for a loan. For example, say Company A issues a collateral trust bond, and as collateral for the bond, it includes the right to Company A shares held by a trust company. If Company A were to default on the bond payments, the bondholders would be entitled to the shares held in trust.
Furthermore, if the issuer defaults on its payments, the voting rights of the shares held by the trustee will be transferred to the trustee which has the option of selling the securities to pay the bondholders.
Collateral trust bonds have lower yields than unsecured bonds since they are perceived to be less risky due to the collateral held by the trustee. Investors will be willing to accept a lower yield on these bonds in return for a guaranteed stream of income and preserved principal investment.