A bond is a debt instrument which is issued by Government agencies and large corporates for raising funds and capital. Irrespective who issues the bond, all bonds issued fall into broadly under two distinct categories, i.e. secured and insecure bonds. When an investor invests in bonds, they need to understand the risks and rewards, pros and cons in investing in these debt instruments.
Secure Bonds
When a bond issued is backed with an asset, it can be called as a secure bond. Assets backing a bond can be liquid assets such as stock, physical assets such as property, plant and machinery.
This implies that in an event the issuer of the bond defaults on its coupon or principal repayment, the bondholders can stake a claim on the assets backing the bond.
For instance, a government agency might decide to issue bonds to finance an infrastructure project, such as a highway project or a bridge.
These bonds can be secured by the income generated from the collection of toll charges from the motorist using the highway or the bridge. Future cash flows or revenue streams secure the said bond, and such secure bonds are also known as revenue bonds.
Corporates can also offer real estate, which usually is a prime property as collateral to the bondholders. These are also referred to as mortgage bonds. In an event the corporate defaults on its coupon or principal payments, the bondholders can recover their dues by foreclosing the property
Unsecured Bonds
Bonds which are not backed by any form of assets is known as an unsecured bond. These are often also referred to as debentures. In any event, the company issuing these bonds are unable to pay coupon payments or repay principal amount, or the company undergoes bankruptcy, the bondholders are not secured, or the repayment of interest and the principal amount is not guaranteed by any form of asset or future revenue stream.
Some examples of unsecured bonds are treasury bills, notes, corporate bonds issued without being backed by an asset. Investors invest in unsecured bonds on the basis of faith, credibility and credit-worthiness of the issuer of the bond.
Risk of Repayment
As the name suggests, secure bonds are considered as a safer option as compared to an unsecured bond. In any event, the company defaults on its coupon payment or principal repayment, the bondholders can recover their dues by liquidating the asset backing the bond. As a result of this, the investor often is ready to invest in secured bonds at a lower rate of interest.
In the case of unsecured bonds, the bondholders do not have any form of security in the event of repayment default or bankruptcy.
While an asset only offers a sense of security to the bondholders, the primary intent of the issuer of the bond is not to default on their timely interest payment and principal repayment at time of maturity of the instrument.
Credit Rating
Credit rating agencies specifically assist investors in understanding the risks involved while investing in a particular form of investment. These rating agencies are independent agencies and assess the ability of the issuer of the borrow to repay their debt and financial obligations. Some of the prominent rating agencies include CRISIL, Moody’s, Fitch Ratings, Standards and Poors.
These rating agencies assign grades or ratings to different forms of investments. A firm’s credit rating is an essential factor which determines its rate of interest and yield.
Bond Features
Investors need to consider a wide array of features of a bond before investing in a bond. This includes the coupon payment or interest rate, tenure of the bond, callable feature of the bond and much more.
For instance, the callable feature of a bond allows the issuer of the bond to repay the principal amount before its maturity date. Also, zero coupon bonds do not pay periodic interest before its maturity, whereas it is issued at a discount to its face value.
The Verdict
Investors should formulate their investment decision base on their financial goals and considered the various features of a bond. While a junk bond can be a considerable riskier investment, it can also offer considerable returns to the bondholder.
Similarly, zero-coupon bonds are useless for an investor seeking regular interest payment but highly significant investment for an investor who wishes to earn substantial long term gains.