Corporations often borrow funds by issuing corporate bonds. Investors lend a company funds by purchasing the corporate bonds issued and become creditors for the corporation. The same company can issue different types of bonds simultaneously. Some may be secured, or senior bonds, and others may be unsecured bonds, or debentures. The degree of risk and level of earnings vary from one issue to another and do not necessarily depend on whether the bonds are classified as secured or unsecured.
Bondholders of secured bonds hold a legal claim to particular assets of the issuer should the corporation default. Different types of collateral can back secured bonds. For example, mortgage bonds are a type of secured bond in which real estate assets provide the collateral for the issue. The proceeds a corporation receives from a mortgage bond issue may be used to pay for the construction of new buildings, with the structures being built providing the collateral for the issue.
Another example of a secured bond is an enhanced equipment trust certificate. A specialized form of secured bond first used by railroads to finance the purchase of new equipment, EETCs are used by transportation companies to pay for the lease and eventual purchase of equipment and supplies. The equipment provides the collateral until the corporation pays bondholders in full.
Debentures are unsecured bonds and give the bondholder no legal claims on assets; no collateral backs the debt. Since unsecured bonds are backed only by the corporation's promise to pay, the quality of the bonds is based on the creditworthiness of the issuer. Should a corporation default on unsecured bonds, the bondholders cannot claim property promised as collateral on other debts.
Most corporate bonds are issued at a par or face value of $1,000 or $5,000, and they generally pay interest semiannually. The indenture, the contract between the issuer and the bondholders, details the legal obligations of the issuer to the bondholders. Corporations tend to issue more bonds when market interest rates are low. However, all bonds carry some degree of interest rate risk regardless of the secured or unsecured provisions of the bond.
Quality and Yield
Comparing yields between an unsecured bond and a secured one is not relevant if the quality of the bonds is similar. Comparative analysis based on the quality of different issues takes into consideration several factors that rating agencies use to grade the issues. For example, bonds with only a slight chance of default are rated highest, regardless of whether secured or unsecured, just as junk bonds are considered speculative grade and carry a high risk. Thus, collateral tied to bonds affects yield only when the quality of the issue and the corporation behind it are considered.
- "Investment Analysis and Portfolio Management"; Frank K. Reilly and Keith C. Brown
- Library of Economics and Liberty: Bonds -- The Concise Encyclopedia of Economics
- Library of Economics and Liberty: Junks Bonds -- The Concise Encyclopedia of Economics
- SIFMA: About Corporate Bonds
- Standard & Poor's: Guide to Credit Ratings Criteria
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