If you're invested in a company that fails, whether your bond is secured or unsecured will play a pivotal role in whether you ever see your money again. When a company issues a bond, it is either secured or unsecured. By knowing the advantages and disadvantages of each type of bond, you can balance returns and risk in a way that complements--and potentially improves--your investment strategy.
When you purchase a bond, you are giving a company your money to borrow for a certain period of time. In exchange, the company agrees to pay you interest on specific dates, at a prescribed rate, until the bond matures. When the bond matures, or comes due, you are paid back the face value of the bond. The ability of the company to meet these obligations varies according to its financial strength.
Financial strength is not always easy to predict. Sometimes even large and apparently strong companies fail. Secured bonds alleviate some of this risk, because the bond is backed by a specific asset or revenue stream. If the company becomes financially strapped, the secured bondholders have first access to that asset, or to revenue provided by the specific asset. If this occurs, investors are able to collect at least a portion of what they are owed
Pros and Cons
As a secured bondholder you are less at risk of losing your investment than unsecured bondholders are. This is the main advantage of a secured bond--safety. The downside is that returns are also generally lower, because there is less risk to you. Another question to consider is what the bonds are secured by: Secured bonds may be backed by the revenue stream of the project the bonds were issued in order to finance. While this provides some security, there is no guarantee the project will produce the expected revenue, and if that project fails, bond holders may still face some losses.
If you believe in the corporation's ability to meet its obligation to you, you may opt to invest in an unsecured bond. These bonds are not backed by anything but your trust and the company's commitment to pay. In the event a corporation goes bankrupt, there are no specific assets that can be sold to repay the bondholders. This additional risk usually means you will receive a higher interest rate than you would if you held a secured corporate bond.
Pros and Cons
In the bond market, a higher risk usually means a higher return. Since the bond is not secured--and you face potential sizable losses if the company goes bankrupt--you receive a higher return from the company for lending it money. If a company is stable, has a long history of meeting its financial obligations and has a good credit rating, the additional risk may be worth the higher return. The return and risk on a unsecured bond can vary greatly, from low-risk and low return to high-risk and high return. Do some research on the company before buying its bond to make sure you feel confident it can meet its obligation to you.
Cory Mitchell has been a writer since 2007. His articles have been published by "Stock and Commodities" magazine and Forbes Digital. He is a Chartered Market Technician and a member of the Market Technicians Association and the Canadian Society of Technical Analysts. Mitchell holds a Bachelor of Management in finance from the University of Lethbridge.