The main difference between mortgage bonds and debenture bonds is collateral. The mortgage bond is collateralized by something that has value and can be sold to pay the bondholders if the company defaults on payment of that bond or goes through bankruptcy. Debentures have no such collateralization. They are unsecured debt, backed only by the full faith and credit of the issuing company. If investors receive only the issuer's promise to pay, they typically require a higher interest rate than they would require to buy a collateral-backed bond.
While mortgage bonds use some form of valuable asset as collateral, debentures are not back by any such asset. With that in mind, debentures can be defined as unsecured debt.
Defining Mortgage Bonds
When a company builds a new factory or buys new equipment, it will pledge those assets as collateral for the money being borrowed in the bond market. The company gets a better interest rate and the bond issue sells quicker than it would if the company simply issued a promise to repay its loans.
A first mortgage bond is senior in rights to receive proceeds, ranking higher than lower mortgage bonds in the series if the collateral is sold to pay bondholders. Many institutional investment funds, such as pensions and foundations, are required to invest only in secured debt or debt backed by the full faith and credit of the U.S. Government.
Debentures and Unsecured Debt
Debentures are unsecured debt. They are backed only by the issuing company's ability to pay timely interest payments and, at maturity, return the principal. If the company fails to do this, debenture holders must wait in line to receive the proceeds of liquidation of the company's assets. Debentures are next in line after all mortgage bondholders have been paid. Senior debentures rank highest, followed by debentures, senior subordinated debentures and subordinated debentures.
Understanding Credit Ratings
If you own a subordinated debenture, your investment is considered riskier than a first mortgage bond. In fact, the subordinated debenture issue most likely carries a lower credit rating than the first mortgage bond of the same company. Because they are considered riskier investments, they also generally have shorter maturities than secured debt.
The degree of risk is contingent upon the credit quality of the issuing company. For example, a subordinated debenture of a company with a AAA credit rating would be less risky than a first mortgage bond issued by a company with a BB, or junk, credit rating.
Evaluating Interest Rates
Coupon rates, which indicate the percentage interest paid annually by the bond, are set when the bond is issued. The higher the credit quality of the bond, the lower the coupon interest rate, relative to the market at the time. The lower the credit quality of the bond being issued, all things remaining equal, the higher the set coupon rate. It is in a company's best interest to issue long-term bonds as senior secured debt, or first mortgage bonds, because the interest cost will be lower. Unsecured debt benefits from shorter maturities of 15 years and under because coupon rates are lower for shorter maturities than for longer maturities.
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