One way to invest your money is by purchasing bonds in the bond market. But most of these debentures are not backed by any asset. Therefore, they are called unsecured bonds. What is it? How risky is it? In this article, we will explain these.
Definition of Unsecured Bond
Unsecured bonds are types of debenture that are not backed by collateral but by the organization’s reputation and ability to pay. This bond can be risky. But some may be risk-free.
Key Explanations of Unsecured Bonds
Types of debenture. Unsecured debts are types of debentures. Other types of debentures are corporate bonds, federal government bonds, mortgage bonds among others. Most of these debentures are unsecured except mortgages. For example, corporate debt is issued by big companies and is listed in a bond market. So is the federal government’s.
Collaterals. Unsecured debentures are not backed by collateral. Generally, it is expected that bonds should be backed by an asset or group of assets. So that, if the company defaults, the assets can be used to pay the remaining debt. However, this is not true with unsecured debts. Here, if the company defaults, what the bondholders can do is to sue them to court for the default.
Risk. Unsecured bonds are riskier than secured debts. Therefore, they earn higher interest rates. Most corporate bonds issued in the bond market are unsecured. These companies are blue chips companies, therefore, repaying the debts to the bondholder is not a problem. Also, the company has a reputation to keep. So, they must repay the debt.
It will surprise you that not all unsecured bonds are risky. Government bonds are unsecured but are risk-free. And attracts less interest rate compared to other debt investments. The coupon rate of federal government bonds is used as a yardstick to measure the interest rate of other types of bonds. If government debt investment carries a 5% interest rate per annum, other debentures’ coupon rates must be higher than 5%.
Unsecured bonds are issued to bondholders without any collateral. To recover their money when there is a default, the bondholders will sue the company. Also, the lack of collateral makes this debenture riskier. The higher risk results in a higher interest rate. However, government bonds are not backed by any security but are referred to as risk-free debts.