Why do secured bonds have less default risk than unsecured bonds? Secured bonds are backed by specific assets of an issuer while Unsecured bonds are backed by all assets of the issuer - so shouldn't Secure Bonds have more default risk?
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5Unsecured creditors get the leftovers after the secured creditors have been paid. Often there’s nothing there.– Pete BeckerCommented Jun 6, 2023 at 18:55
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2 Answers
Unsecured bonds are backed by all assets of the issuer
No, they are not secured by any specific assets (hence "unsecured").
With a secured bond, in the event of default, the bondholders automatically take ownership of the assets used to secure the loan and can sell them to pay off the remaining debt. The issuer often must ensure that the value of the assets is enough to completely pay off ("cover") the bonds, and is restricted from selling them (similar to how you can't sell a house or car that you have a loan on without paying off the loan first).
With unsecured bonds, there are no assets used to collateralize the loan. If the bond issuer defaults (i.e. cannot make a coupon payment), some manner of legal action (typically bankruptcy) must be taken to recover any part of the bond. That recourse may come from a sale of remaining assets, but there are no specific assets pledged to the debt.
Secured loans often have lower coupon payments, which is a tradeoff for increased safety for bondholders and restricted use of assets for bond issuers.
Since the recovery rate is higher for secured bonds, there is less overall default risk.
answered Jun 6, 2023 at 12:26
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3Exactly. "Security" means what it says, and "unsecurity" means what it says.– RonJohnCommented Jun 7, 2023 at 0:53
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2What do you mean by this: "The bondholder either declares bankruptcy or is sued to pay back the bonds...." The bondholder isn't at any risk of bankruptcy as he can't lose any more than what he invested in the bond. Do you mean the issuer? The issuer can't just declare bankruptcy. The issuer MUST pay back the bonds (in order of seniority) to the bondholders insofar as possible. Only then does bankruptcy become an option. There's no need to sue, as the obligation is in the covenant of the bond. You might want to update that part of your answer.– Ellie KCommented Jun 7, 2023 at 18:36
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3@EllieKesselman Good catch - I corrected the holder-->issuer part. As far as bankruptcy vs lawsuit, I was more trying to illustrate that no assets are conveyed to the bondholder in event of default for an unsecured bond, and some form of legal action must occur to get any recourse. I was not focused on the actual legal mechanics as much. I'll make that more general. Commented Jun 7, 2023 at 19:00
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Secured bonds are specifically backed by a particular collateral. Unsecured bonds are "secured" by the debtor's assets, but a secured bond is also secured by the debtor's assets, as well as the collateral. If the collateral isn't enough to pay off a secured bond, the debtor doesn't get to say "Too bad, that's all you get" [1]; the creditor can claim the collateral and go after the rest of the debtor's assets.
[1] There is such thing as a "no recourse" loan, where the creditor can't go after other assets, but generally speaking, bonds aren't no-recourse. Although the corporation as a whole is a limitation on recourse, as it allows stock holders to shield their personal assets.
