As a retail investor, investing in bonds can provide a steady source of income and diversify your portfolio. However, with so many options available, it’s important to understand the advantages and disadvantages of each type of bond.
Secured Bonds
Secured bonds are backed by collateral or assets, which are pledged by the issuer to the bondholders. The collateral could be in the form of property, equipment, or other tangible assets. In case the issuer defaults on the bond payment, the bondholders have the right to claim the collateral to recover their investment. The security provided by the collateral makes secured bonds less risky than unsecured bonds.
Unsecured Bonds
Unsecured bonds, also known as debentures, do not have any collateral backing them. These bonds are issued solely based on the creditworthiness of the issuer. The issuer promises to pay back the principal amount along with interest to the bondholders.
Unsecured bonds are typically issued by corporations, financial institutions, and government entities. In the corporate world, unsecured bonds are often issued by companies with good credit ratings and solid financial positions. These companies have a track record of generating steady cash flows, which gives investors confidence that they will be able to pay back the bondholders.
Government entities such as municipalities and state governments also issue unsecured bonds. These bonds are often used to finance public projects such as infrastructure development, education, and healthcare. The creditworthiness of government entities is usually strong, which makes investing in their unsecured bonds less risky compared to other issuers.
Secured Bonds vs. Unsecured Bonds
Risk:
Secured bonds are considered less risky than unsecured bonds because they are backed by collateral. This means that if the issuer defaults on the bond, the investors can recover their investment through the sale of the collateral. For example, a mortgage-backed security is a type of secured bond where the underlying asset is a mortgage on a property. If the borrower defaults on the mortgage, the lender can foreclose on the property and sell it to recover their investment.
On the other hand, unsecured bonds do not have any collateral backing them, making them riskier for investors. If the issuer defaults on the bond, the investors may not be able to recover their investment as there is no collateral to sell. Instead, they may have to rely on the issuer’s ability to pay back the bondholders.
Returns:
Investors who are seeking higher returns may find unsecured bonds more appealing as they generally offer higher returns compared to secured bonds. This is because unsecured bonds are considered riskier investments due to the lack of collateral backing them. In contrast, secured bonds usually offer a lower interest rate than unsecured bonds because they are considered less risky. However, it is important to note that in some cases, such as when the issuer has a good credit rating, a secured bond may offer higher returns compared to an unsecured bond.
Liquidity:
Unsecured bonds are more liquid as compared to secured bonds as they can be easily traded in the secondary market, making it easier for investors to buy and sell them. Secured bonds on the other hand are less liquid compared to unsecured bonds as they are backed by collateral, which limits their tradability. In some cases, the underlying asset may not be easily sellable, which can make it difficult for investors to recover their investment.
In conclusion, secured and unsecured bonds differ regarding collateral, risk, return, and liquidity. Secured bonds offer a layer of protection to investors, while unsecured bonds provide higher returns. Understanding these differences can help investors make informed investment decisions based on your risk appetite and objectives.
