What Is a Secured Bond?
A secured bond is a type of bond that is secured by the issuer's pledge of a specific asset, which is a form of collateral on the loan. In the event of a default, the bond issuer passes title of the asset onto the bondholders. Secured bonds can also be secured with a revenue stream that comes from the project that the bond issue was used to finance.
Secured Bond Explained
Secured bonds are seen as less risky than unsecured bonds because investors are compensated at least somewhat for their investment in the event of default.
Some types of secured bonds are mortgage bonds and equipment trust certificates. Secured bonds are collateralized by assets such as property, equipment or another income stream. For example, mortgage-backed securities (MBS) are backed by the titles to the borrowers’ houses 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.
Secured Bonds Issued by Municipalities
Municipalities typically issue secured bonds backed by the revenue anticipated from a specific project. Municipalities may also issue unsecured bonds, or general obligation bonds, backed by the municipality’s taxing power.
In some cases, investors’ claims on a borrower’s assets may be challenged, or the sale of the asset may not give back the entire principal to investors. Especially in cases involving legal action, investors may not receive all of their principal.
First Mortgage Bonds
Companies holding significant real estate and property may issue mortgage bonds using those assets as collateral. As large owners of land, power plants, power lines, and equipment, many utility companies issue first mortgage bonds for securing loans at a lower cost than unsecured bonds. Bondholders have first claim to the underlying property in case the company does not make principal and interest payments as scheduled.
Documentation associated with a first mortgage bond contains a first mortgage on at least one of the issuer’s properties. Because of the mortgage, the bondholder is a secured lender and has first claim on the underlying assets in case of default. Bondholders may liquidate the assets and use the proceeds to get back their initial investment.
If the issuer has enough cash for paying off its creditors, rather than selling the underlying assets, the company uses the cash for paying the first mortgage bondholders before others. Because the bonds carry less risk, they offer lower interest rates than unsecured bonds.
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. Investors purchase trust certificates as a means of providing capital used to purchase equipment or finance operations. The company makes scheduled payments to the trust, providing principal and interest income to investors. When the debt is repaid, the asset’s ownership transfers from the trust back to the company.