When you need a loan, collateral can make the difference between approval and denial. It also can lower the rate of interest you'll pay. However, lenders vary in the types of instruments they will accept as collateral for a loan. Generally, tax-free municipals are accepted, although risky ones might not be valued highly.
Tax-free municipal bonds pay interest that’s free from federal tax and from tax in the state of issuance. Some municipal bonds are insured, but the vast majority is not. When you buy these bonds, your broker usually holds the certificates for you in “street name,” which allow the broker to sell the bonds on your behalf. However, you might hold the certificates yourself if they are available in paper form -- some bonds are issued in electronic form. If you hold the bonds you want to pledge, you’ll have to deliver them to the lender or to a third-party escrow account. Municipal bonds have price risk and default risk, both of which affect their value as collateral.
When you use municipal bonds as collateral, the lender will normally take physical position or attach a lien on bonds located elsewhere. To attach a lien, the lender will file a financing statement with the state or local authorities detailing the bonds’ serial numbers and locations. The lien allows the lender to sell your bonds if you default on your loan. Your lending agreement will set out the lender's procedure for cashing your bonds if the need arises. If the lender cashes the collateral, you receive any amounts in excess of the money you owe.
When you put up your bonds as collateral, their value is determined by current market prices. However, you normally will not realize 100 cents on the dollar when you pledge securities. For example, your lender might credit you 80 percent of the bonds’ value, which in industry lingo is a 20 percent “haircut.” You must therefore over-collateralize a loan with extra municipal bonds to account for the haircut percentage. The haircut protects the lender from the risks that your bonds might lose value or go into default. You normally continue to receive your interest payments on the collateralized bonds, but it’s possible that the loan agreement will require the addition of those payments to the collateral.
A margin account allows you to borrow money from your broker to pay in part for security trades. Normally, the securities that you buy serve as collateral in the margin account. However, if you short stock -- borrow shares from your broker and sell them to a third party -- you must put up at the full sale proceeds plus an additional 50 percent to 100 percent as collateral. Your broker might be willing to accept your municipal bonds as collateral after applying a suitable haircut. You’ll have to deposit the bonds with the broker. If the short sale goes against you -- meaning that the stock price rises -- you will receive a margin call from your broker demanding more collateral. If you don’t respond immediately, your broker will sell your bonds and use the money to buy back its shares.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.