Bonds are debt instruments issued by governments and corporations. Corporate bonds can be secured or unsecured. A secured bond means that the issuer sets aside certain assets as collateral. In default, secured bondholders can lay claim to those assets to recover their investment. Unsecured bonds have no specific collateral backing. In default and bankruptcy, they are paid out of a corporation’s general fund in an established order of priority.
Secured bonds have specific corporate assets pledged as collateral. The safest (and most popular) are bonds secured by real assets such as plants or buildings, called mortgage bonds. In default, bondholders can lay claim to those plants or buildings to recover their investment. Mortgage bonds may be further classified as first or second mortgage bonds, just like first and second residential mortgages.
Debentures do not have any specific collateral pledged and are backed by the general credit of a corporation –- in effect, by a corporation’s promise to pay. That is why corporate credit ratings that take into account credit history are so important in assessing a debenture’s safety – they tell investors how likely a corporation is to fulfill its promise to pay.
If a corporation defaults and files for bankruptcy, its obligations are paid off in an established order of priority. Secured bondholders are paid first with the proceeds from the sale of collateral assets. A mortgage bond is considered very safe, therefore, especially if the real assets pledged as collateral have appreciated in value over time and more than cover the bond amount. All other bonds are paid out of the remaining general pool: senior bonds, debentures and junior debentures.
Risk of Loss vs. Interest Income
Since debentures carry a higher risk of loss, they pay higher interest as compensation for that risk.
Some corporate raiders may use bonds to take control of a corporation. They typically use high-risk bonds, including debentures, to achieve their goal. If a corporation gets into financial trouble, its bonds drop in price, reflecting a high level of uncertainty over future payments. Secure bonds drop less because they are secured by specific assets, but general obligation bonds and subordinated bonds may sometimes trade for pennies on the dollar. A corporate raider may buy up enough of those debentures to become the largest creditor, force the corporation into bankruptcy and dictate the terms of a takeover.