Contents
Collateral backing refers to assets or financial guarantees that secure a bond issue. It provides additional protection for bondholders beyond the issuer’s simple promise to pay. In the event of default, these assets can be liquidated to repay bondholders, reducing the risk of loss.
For example, if a corporate bond is secured by real estate, the lender can seize and sell the property to recover the outstanding debt. Similarly, if specific tax revenues back a government bond, these revenues can be used to repay the bondholders, even if the government faces financial difficulties.
By understanding the specific collateral backing a bond, investors can assess the risk associated with the investment. Bonds with strong collateral backing are considered less risky than those without collateral. However, it’s important to note that the value of collateral can fluctuate over time, and unforeseen events may impact its ability to provide full protection to bondholders.
Types of collateral backing
Various forms of collateral back different types of bonds:
- Collateral trust bonds
- Equipment trust certificates
- Mortgage-backed securities (MBS)
- Covered bonds
Collateral trust bonds
A pool of securities, such as stocks, bonds, or other financial assets, secures collateral trust bonds. A third-party trustee holds these assets in trust, overseeing their value and ensuring they are used to repay the bondholders in case of default.
By pledging these securities as collateral, the issuer can enhance the bond’s creditworthiness and attract investors seeking a lower level of risk. This additional layer of security typically results in lower interest rates for collateral trust bonds compared to unsecured bonds.
Equipment trust certificates
Equipment trust certificates represent a unique form of secured debt. They are typically issued by corporations that own and lease out specialized equipment. For example, an airline might issue equipment trust certificates backed by a fleet of aircraft.
Due to the tangible nature of the underlying collateral, these certificates offer investors a high degree of security. In default, the equipment can be seized and sold at a public auction. The proceeds from this sale are then used to repay the outstanding debt to the certificate holders. This direct link between the debt and the valuable assets provides a strong level of protection for investors.
Furthermore, the cash flows generated from the equipment leases are used to make regular interest and principal payments to the certificate holders. This consistent income stream enhances the certificates’ creditworthiness and makes them attractive to investors seeking relatively stable returns.
Mortgage-backed securities (MBS)
Mortgage-backed securities (MBS) are a significant segment of the fixed-income market. They are created by pooling many mortgages, such as residential or commercial property loans. The pools of mortgages are then securitized into tradable bonds.
When investors purchase an MBS, they essentially become part-owners of a diversified portfolio of mortgages. The cash flows generated from these mortgages, including principal and interest payments, are passed through to the MBS investors. This pass-through structure allows investors to participate in the housing market’s growth.
However, it’s important to note that MBS can be subject to significant interest rate risk. As interest rates rise, the value of existing mortgages may decline, potentially impacting the value of the MBS. Additionally, changes in housing market conditions, such as a decline in home prices or an increase in mortgage delinquencies, can also adversely affect the performance of MBS.
Covered bonds
Covered bonds are asset-backed securities backed by a segregated pool of assets known as the cover pool. Unlike traditional asset-backed securities, the underlying assets of a covered bond remain on the issuer’s balance sheet. This means bondholders have recourse to the cover pool and the issuer’s general assets in the event of default.
One key distinction between covered bonds and traditional asset-backed securities is the level of protection offered to bondholders. Due to the additional layer of protection provided by the issuer’s general assets, covered bonds typically have a higher credit rating than traditional asset-backed securities. This higher credit rating often translates into lower interest rates for covered bond investors.
Do unsecured loans have collateral backing?
One crucial factor to consider is the bond’s seniority ranking. Seniority determines the order in which bondholders are repaid in the event of default.
Secured bonds are backed by specific assets or financial guarantees, giving bondholders a higher priority claim on these assets than other creditors. In the event of default, secured bondholders have the right to seize and sell the collateral to recover their investment. This additional layer of protection typically results in lower interest rates for secured bonds.
Unsecured bonds, also known as debentures, are not backed by specific collateral. Instead, they rely solely on the issuer’s creditworthiness. Unsecured bondholders have a lower priority claim than secured bondholders, which means they may receive less in the event of default. Unsecured bonds typically offer higher interest rates than secured bonds to compensate for the increased risk.
⬡ Start Your Journey Here: Fixed Income Basics.
