What it means
When a company or government issues a bond, it borrows money from investors and promises to pay interest and return the principal on a set date. With a secured bond, the issuer also pledges assets such as property, equipment or receivables as security.
If the issuer defaults, a trustee acting for the bondholders can take and sell those assets to recover what is owed. Common types include mortgage bonds, which are backed by real estate, and equipment trust certificates, which are backed by assets such as aircraft or railway cars.
Asset-backed bonds are paid from a pool of loans or receivables. The legal documents, called an indenture, describe which assets are pledged and what rights bondholders have.
The security gives bondholders a higher place in the queue if the issuer fails. They are paid from the pledged assets before unsecured creditors can take anything from them.
This is why secured bonds usually carry lower yields than unsecured bonds from the same borrower. There are limits to the protection.
The assets may be worth less than expected when sold in distress, and the collateral may be shared with other lenders. Investors should look at the value and quality of the assets, how much debt they support and how easily they can be sold.
For issuers, secured bonds offer cheaper borrowing but tie up assets and limit flexibility. Pledged assets cannot easily be sold or used for other loans without the bondholders' agreement.
Finance teams weigh the lower interest cost against these restrictions. Credit rating agencies treat secured bonds differently.
A bond with good collateral may receive a higher rating than the issuer's unsecured debt, which lowers borrowing costs further. Investors should still check the rating reasoning, since it depends on the value and legal strength of the pledged assets.
In practice
Real-world examples.
Example
A property company issues $50,000,000 of mortgage bonds secured on a portfolio of office buildings. Investors accept a lower interest rate because they can claim the buildings if the company defaults. The company saves on annual interest compared with unsecured borrowing, although it cannot sell the pledged buildings without the trustee's consent.
Example
A regional airline funds the purchase of new aircraft by issuing bonds secured on the planes themselves. The bondholders can repossess the aircraft if payments stop. The airline is able to borrow at a lower cost than on an unsecured basis.
Example
A utility issues $200,000,000 of first mortgage bonds secured on its power stations and grid assets. Investors treat the bonds as lower risk, and the utility pays a lower coupon (the yearly interest rate) than it would on unsecured borrowing. The utility accepts that it cannot sell the pledged assets freely.
Formula
Calculation
Asset coverage ratio = value of pledged assets / bond principal
A company issues $10,000,000 of secured bonds backed by a building valued at $12,000,000. The asset coverage ratio is $12,000,000 / $10,000,000 = 1.2. This means the pledged assets are worth 1.2 times the bonds, giving bondholders a 20% cushion, or $2,000,000, if values fall.Case study
Seen in the real world.
Redstone Shipping is a fictional company that wanted to raise $30,000,000 to buy two vessels. Its treasurer, Hannah, compared an unsecured bond at 8% with a secured bond backed by the ships at 6%.
The secured version saved 2 percentage points, or $600,000 a year on the $30,000,000 raised. In return, the ships could not be sold without the bondholders' consent. This is an illustrative story, but it captures the trade-off: Hannah chose the secured bond, accepting the restriction because she planned to keep the ships for many years.
Hannah also agreed with the trustee to report the value of the ships each year. If their value ever fell below 120% of the bonds outstanding, Redstone would have to add collateral or repay part of the debt.
Watch out
Common mistakes.
- Assuming a secured bond is risk-free. The collateral may fall in value, so bondholders can still lose money.
- Confusing secured with guaranteed. A guarantee is a promise from a third party, while security is a claim on specific assets.
- Ignoring the ranking of other lenders. Another creditor may have a prior claim on the same assets.
Questions
People also ask.
What is the difference between a secured and an unsecured bond?
A secured bond is backed by specific assets that bondholders can claim on default, while an unsecured bond relies only on the issuer's general promise to pay.
Why do secured bonds pay lower interest?
The collateral reduces the risk of loss, so investors accept a lower return. The saving can be large for an issuer that borrows heavily over many years.
What is a mortgage bond?
It is a secured bond backed by real estate or other property owned by the issuer.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related