Unsecured Bonds

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What are Unsecured Bonds?


Unsecured bonds or debentures are bonds that are not backed by some type of collateral. In other words, the bond is only secured by the bond issuer’s good credit standing. There are no building, equipment, vehicles, or other assets backing up the bond. If the bond issuer defaults on the unsecured bond, the bond holders could receive nothing from their investment. They would be left up to the court system to sue the bond issuer for their investment. 
A bond that has no specified source of collateral is considered an unsecured debt instrument. Therefore, unsecured debt often pays higher yields than secured debt due to lack of a direct collateral coverage. There are three types of unsecured debt: debentures, Income bonds and subordinated debentures.

  • Debentures

A debenture is a type of bond that does not use collateral. It's otherwise recognized as any unsecured long-term debt. Because the bonds are unsecured, it's imperative for the issue to be profitable for the corporation. Because of its lack of collateral this makes the bond more risky. This risk means the bond should pay a higher interest rate in order to compensate for the risk. The greater the risk the greater the interest rate should be because the issue does not have collateral to pay in case the corporation is not profitable.

Examples:

Examples of debentures are Treasury bonds and Treasury bills.

  • Income Bond:

A bond in which the issuer is only responsible for making coupon payments when it has sufficient income to do so. Income bonds are most common in reorganization plans in which the issuer is attempting to maintain operations in bankruptcy. An income bond is useful for the issuer because it provides capital quickly. However, it can be disadvantageous for the bondholder because there is little or no guarantee of repayment. As a result, income bonds are relatively rare securities.

  • Subordinated Debentures:

A subordinated debenture is similar in character however in this case they are payed as a subordinate issue. This leaves the subordinate debenture acting as a junior debt to the more senior debenture in case of insolvency. As you might imagine these issues, although linked to the debentures, pay a higher interest rate.

In the case that the corporation does become insolvent, the more subordinated a note is the more risky it would be. Imagine a series of issues with senior debt and junior debt this flow of funds from the corporation to the bond investors happens like a funnel.

Example

If a company can’t raise enough capital to back a bond issuance, it is usually a sign of a risky investment. Governments, on the other hand, can always raise taxes if they need to pay off bond holders. An unsecured bond from a municipality is usually a safe investment. Even in the rare circumstance that a governmental body declares bankruptcy, the bonds are usually covered by other governmental bodies.

Since unsecured bonds are more risky to investors than secured bonds, unsecured bond issuers usually have to pay a higher interest rate to the bond holders. Depending on the company or governmental organization, the interest rate could be one percent or ten percent. This rate difference largely depends on how trustworthy and financially stable the company or governmental organization is.


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