Bonds are a type of investment in which money is lent to a borrower in exchange for a fixed rate of return. Many bonds are unsecured, meaning that there is nothing concrete to back up the bondholder’s investment, just the promise of the bond issuer to pay the bondholder back. A secured bond, on the other hand, is backed by assets, usually physical ones such as real estate, which are liquidated in the event that the bond issuer cannot pay back the borrowed funds.
While bonds are generally considered to be a fairly safe investment, there is a degree of risk, as with every investment. Secured bonds aim to reduce that small risk even further, although there is no way to completely eliminate risk. A secured bond is secured by a mortgage or other similar lien. If the bond issuer, whether that be a corporation, local government, or other entity, cannot pay back the bond with interest at the end of the term, the title to the mortgage or other asset is transferred to the bondholder.
A secured bond is somewhat of a misnomer, since it is not secured in the same way as a secured credit card is, in other words, with cash. If the bond is secured by a mortgage, which is most common, there is no guarantee that the mortgage itself will not be in default, or that the underlying real estate will still be worth the value of the mortgage. In this case, the bond is not fully secured, but its risk is reduced compared to if there were no backing at all.
All bonds pay a rate of interest as an incentive to the investor to buy a bond. The interest becomes the return on the bondholder’s investment when the bond is paid back. The riskier the loan, the higher the rate of interest that it will bring. High-risk or so-called “junk bonds” pay a high rate of interest because of the greater risk of default. A secured bond is at the other end of the risk spectrum, and because of its very low risk, it pays lower interest rates compared with other bonds.
Most investors are able to tolerate the small amount of risk that is inherent in investment-grade corporate bonds or similar instruments, even though these are technically unsecured. Not only is the risk of default relatively small with these bonds, but if a company were to go under, the company’s bondholders have the first claim on anything that is left. For reasons like these, secured bonds are not widely known or purchased, but if capital preservation is the single overriding goal of a portfolio, a secured bond may be a wise addition to it.