Two corporate bonds can offer the same coupon over the same term and carry completely different levels of risk. The difference is usually in one word on the front page: secured.
Security is the investor’s claim on specific assets if the issuer cannot pay. It is often the single biggest factor in what an investor recovers when things go wrong, and it is also one of the most misunderstood. This is how it works, and what to check.
Unsecured bonds
An unsecured bond is a straightforward promise to pay. If the issuer defaults, bondholders become unsecured creditors. They are paid only after secured lenders have been repaid from the assets they hold charges over, and alongside every other unsecured creditor: suppliers, landlords, sometimes tax authorities, depending on the jurisdiction.
In practice that often means recovering a small fraction of the capital, or nothing. Unsecured bonds are therefore priced mainly on the strength of the issuer: its cash flow, its balance sheet and its track record. Large, established companies can borrow unsecured because their credit is strong. Younger issuers usually cannot.
Secured bonds
A secured bond gives bondholders a legal charge over identified assets. If the issuer defaults, those assets can be sold and the proceeds used to repay the bondholders before other creditors are paid from them.
The security can take several forms:
- A fixed charge over a specific asset, such as a property, a vessel, equipment or shares in a subsidiary. The issuer cannot sell the asset without the bondholders’ consent.
- A floating charge over a changing pool of assets, such as stock or receivables. It gives wider coverage but typically ranks behind fixed charges and some preferential creditors.
- A debenture combining both over most of the issuer’s assets.
- Guarantees from a parent company or another party, which are not security over assets but add a second source of repayment.
Four questions that decide whether the security is real
1. What is the asset worth, and who says so?
Investors should expect an independent, recent valuation from a qualified valuer, not a figure from the issuer’s own forecasts. The key number is loan-to-value: the amount of debt as a percentage of the asset’s value. The lower it is, the bigger the cushion if the asset has to be sold in a hurry, at a discount.
2. Who else has a claim on it?
Security is only as good as its ranking. A second charge behind an existing bank loan is worth far less than a first charge. Investors should see confirmation of every existing charge over the asset, and where the bond will sit.
3. Who can enforce it?
Hundreds of individual bondholders cannot practically act on their own. Well-structured bonds appoint an independent security trustee or agent to hold the security on behalf of all holders and to enforce it if the issuer defaults. Without one, enforcing the security can be slow, costly and contentious.
4. Can the asset actually be sold?
A specialist asset in a thin market, a half-finished development or equipment that only one buyer wants may be worth much less in an enforced sale than on a valuation report. Investors should think about who would buy it, how quickly and at what discount.
How security changes the price
Because secured bondholders take less risk, secured bonds usually pay a lower coupon than unsecured bonds from a similar issuer. That is the trade: investors give up some return in exchange for a stronger position if things go wrong.
For issuers, offering good security is often the difference between raising and not raising, particularly for asset-heavy businesses such as property, infrastructure, energy and equipment finance. Our overview of bonds or loan notes explains why asset-backed raises often suit the bond format.
Common weaknesses we see
- Security over an asset the issuer does not yet own, with no clear mechanism for the charge to attach once it does.
- Valuations based on a completed project when the asset is still being built.
- Charges that were agreed but never registered, which may be unenforceable against other creditors.
- No security trustee, leaving individual investors to act alone.
- Asset values that support the debt only if every assumption goes right.
None of these make a bond unsuitable on their own. They change the risk, and investors are entitled to see them clearly.
Rules vary by jurisdiction
How security is created, registered and enforced differs significantly from country to country, and cross-border structures add another layer. A bond issued by a company in one country, secured over assets in another and sold to investors in several more, needs legal advice in each.
The short version
Unsecured bonds are a bet on the issuer. Secured bonds are a bet on the issuer backed by a claim on specific assets, but only if that claim is valued honestly, ranks where it should and can be enforced in practice. Read the security before you read the coupon. And if you are an issuer considering a bond to replace existing borrowing, see refinancing company debt with a bond.
Mark Johnson is a Director of BDM Wealth Management, which introduces capital raising opportunities across bonds, loan notes, IPOs and SEIS/EIS. To discuss a raise, get in touch.
BDM Wealth Management is an introduction business and is not regulated. This article is general information, not financial, tax or legal advice, and does not constitute an offer or invitation to invest. Capital is at risk and you may get back less than you invest. Tax treatment depends on individual circumstances and may change. For high-net-worth and sophisticated investors only. Take independent professional advice before making any investment decision.