Secured Bond

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What are Secured Bonds?

A secured bond is a bond that requires the issuer to pledge specific assets as collateral in the case of default. Secured bonds are usually more popular with businesses or governments that are less likely to be able to pay their debts in the future. Interest on these bonds isn’t enough to attract investors. Companies and local governments will less than stellar past financial track records usually need to assure inventors that they will not default on their future principle and interest payments. And if they do default, ensure the investors don’t walk away empty handed.


 Example

A good example of a local government that will probably need to issue secured bonds in the future is the city of Detroit. Since its 2013 bankruptcy, its difficult to believe an investor would want to put his or her money at risk purchasing a bond issued by the city of Detroit. I doubt it will ever be able to issue a bond without having some kind of secured collateral agreement attached to it.

The collateral agreement could include any assets the city owns. It could even include rights to public spaces like parking meters and garages. The rights to run parking meters are actually extremely valuable; however, most secured bonds include physical assets that can be sold readily at auction.

Types of Secured Bond

 Types of Secured Bond

  • Mortgage Bonds

Mortgage bonds are typically backed by real estate holdings or tangible property such as equipment. In case of default, the mortgage bondholders can sell off the underlying pledged property and get compensated for the invested amount—the ownership of the asset shifts to bondholders in case of default. As mortgage bonds are safer than corporate bonds (no collateral), they have a lower rate of return.

  • Equipment Trust Certificate (ETC)

ETC refers to debt instruments that allow the issuing company to take possession and use the asset while paying the bondholders over the period of time. The ownership of the asset is, without a doubt, belongs to the bondholders, but the company can use and generate income out of it. Investors supply capital by buying certificates; in turn, helping firms buy assets and lease it to them for operations if the borrower can meet lenders’ payment requirements, the ownership is transferred to the borrower. In case of default, the lenders get to choose what needs to be done with the assets.

Firms need not pay property tax on an asset as they have just leased the same from investors and thus increase their profitability from operations. These types of debentures are usually seen in the airline and shipping industry (also with railway cars).

  • Secured Bonds by Municipalities

Municipalities can raise funds from investors through the issue of these types of secured bonds for a specific project. The bonds are backed by the anticipated revenue from that particular project. Upon disclosing the project’s details and anticipated revenue from the same, municipal bodies put front the repayment strategy or plan to the investors. Depending on the trust of investors in the projects, they can buy these types of bonds.

Advantages:

  • The limited or negligible risk for the principal repayment: As a collateralized asset backs the bonds, the bondholder’s principle can be repaid in case of default by selling an asset.
  • Firms can avail tax benefits during purchase and evade property tax on assets leased in case of ETC deals.
  • An investor gets show bonds as long term investments and gets tax shields significantly on their regular income.
  • Coupon payments or interest payments will generate cash flow (yearly/quarterly/monthly) for the investor.
  • Buying secured bonds backed by revenue streams will generate cash flow for investors upon the efficient execution of projects.
  • Investors can pledge the bonds to raise money for banks or trade bonds in markets and benefit from trades.
  • Firms can use secured bonds to raise extra capital in case if need be.
  • Firms can lower the monthly repayment overheads by spreading them for a longer period of time.
  • Convertible bonds give investors the right to convert to equity and reap profits out of it.

Disadvantages:

  • If the market interest rate raises than the bond rate, the investor experiences losses as his coupon payment will be lesser than market payment (in case of fixed interest rate).
  • When the interest rate rises in the market, the bond value goes down, and if the investor wants to liquidate the bond will get paid less than the market.
  • If the market value of the collateralized asset depreciates, the principal amount repayment gets affected in case of default.
  • In a rising economy, the bond rate will get affected unless the coupon rate is pegged to market rate.
  • In case of an economic recession, when the market value of asset depletes, the investor’s principal is stuck or only lesser than the usual amount can be retrieved.
  • The interest rate on secured bonds is costly from a firm perspective in terms of a mortgage.

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