Secured Bond

A secured bond is a bond whose repayment is guaranteed by a pledge of specific assets belonging to the issuer. If the issuer fails to pay interest or principal, the bondholders, usually acting through a trustee, have a legal claim on those assets and can take or sell them to recover what they are owed. The pledged assets are known as collateral, and the bondholders' claim over them is a lien.

Secured bonds contrast with unsecured bonds, called debenture bonds in US usage, which are backed only by the issuer's general creditworthiness. Because secured bondholders have a stronger claim, they face less risk and normally accept a lower interest rate. The terms of the security, including what is pledged and what the issuer may and may not do with it, are set out in the bond indenture.

• Mortgage bonds are secured by real estate, such as factories, office buildings or, for utilities, power plants and networks. First mortgage bonds have the first claim on the property.
• Equipment trust certificates are secured by specific equipment, such as aircraft, railcars or ships. Legal title is often held by a trustee until the debt is repaid, which makes repossession easier.
• Collateral trust bonds are secured by financial assets, such as shares or bonds of subsidiaries, held by a trustee.
• Asset-backed securities are bonds secured by pools of loans or receivables, such as car loans or credit card balances, usually issued through a separate legal entity.

In a bankruptcy, secured bondholders are paid from the value of their collateral before unsecured creditors receive anything from it. This position in the debt seniority ranking is why senior secured debt historically recovers a higher share of its face value after default than unsecured debt. If the collateral is worth less than the debt, the shortfall usually becomes an unsecured claim against the issuer's other assets. Credit rating agencies often rate an issuer's secured bonds one or more notches above its unsecured bonds for this reason.

A regional railway company needs $200 million. Its unsecured bonds would require a yield of about 6.5 percent, but bonds secured by its rolling stock can be sold at 5.75 percent. On $200 million of ten-year bonds, the secured structure saves 0.75 percentage points, or $1.5 million a year in interest, $15 million over the life of the bonds, ignoring compounding.

In return, the company accepts restrictions. The indenture may prevent it from selling the pledged railcars without replacing them, require it to insure and maintain them, and limit further borrowing secured by the same assets. If it defaulted and the railcars were sold for $170 million, the bondholders would receive that amount and hold a $30 million unsecured claim for the balance.

For the issuer, a secured bond is recorded in the same way as any other bond: bonds payable at face value, with any premium or discount amortized over the term and interest recorded as bond interest expense. The pledged assets stay on the issuer's balance sheet. However, US GAAP and IFRS require disclosure of assets pledged as security, so readers can see that those assets are encumbered assets and not freely available to other creditors. Bonds due after one year are reported among long-term liabilities, with the portion due within a year shown as current.

For investors, the security reduces credit risk but does not remove it. The value of collateral can fall sharply in the same conditions that cause a default, as happened with aircraft values in some airline bankruptcies, and enforcing a claim can take time and legal costs. Investors therefore look at the quality, liquidity and valuation of the collateral, not just the fact that a bond is secured.