Covered vs Uncovered Bonds: MintGenie Explains the Key Differences

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Bonds are loans made by investors to borrowers such as governments and corporations. The investor earns interest on the investment while the borrower uses the funds to support its operations. Many financial advisors agree that bonds can be a great addition to your investment portfolio when used carefully in conjunction with stocks and other assets.

No matter who issues a bond, it can be divided into 2 categories. There are secure and non-secure. Any investor should be aware of the differences between these two types. Let’s start by understanding covered and uncovered bonds in detail.

Covered bonds

A bond is qualified as a “covered bond” if it is backed by an asset class. If a surety is guaranteed, meaning that there is collateral to back the loan, it is said to be secured. The warranty may be in the form of liquid inventory or tangible assets such as real estate, equipment or machinery.

For example, mortgages are secured loans, and if you don’t pay them off, the bank will foreclose on your house. Similarly, a bond is secured if it is accompanied by a guarantee. The collateral will be liquidated (sold) and the proceeds distributed to the bondholders if the issuer is unable to pay the interest and/or principal due to the bondholders.

Unsecured bonds

Unsecured bonds, also known as debentures, are secured by the “entire confidence and credit” of the issuer rather than a specific asset. In other words, the investor has the promise of reimbursement from the issuer, but no right to a specific guarantee.

In the event that the company issuing these bonds goes bankrupt and fails to make payments to its shareholders, repayment of the unpaid principal as well as interest is not guaranteed. This is due to the absence of assets or potential sources of income that could be used as collateral. The deposit is therefore “unsecured”.

Main differences

Secured bonds are generally considered safer investments than unsecured ones. The asset used as collateral can be sold if the company starts having financial difficulties in order to help it pay its debts. Holders of unsecured debt, however, have no real right to monies owed if a company liquidates its assets through bankruptcy proceedings.

Additionally, covered bonds often have lower interest rates because they carry less risk. In contrast, because they carry higher risk, most debentures offer significantly higher interest rates.

In most cases, covered bond issuers are small, unrecognized companies. Established companies, on the other hand, typically issue debentures. This is because investors would only provide their money to reputable companies.

For investors who don’t want to take too much risk, covered bonds are ideal. Conversely, the risk associated with debentures is higher. However, debentures issued by large corporations are considered less risky.

Debentures and secured bonds are also popular with investors, despite the riskier nature of debentures. A person’s financial goals, including their time horizon, risk tolerance and projected return, should be considered when deciding whether to invest in secured or unsecured bonds.

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