While investors can buy both secured bonds or unsecured bonds, the main difference between the two is the amount of risk for the investor. Secured bonds are secured with collateral, e.g. by an asset or assets of commensurate value. Unsecured bonds are not secured with collateral, but investors who buy these bonds put their faith in the creditworthiness of the issuing company.
An example of a secured bond might be a mortgage bond, which is secured by the value of the underlying mortgage as well as the payments on that mortgage. An unsecured bond might be issued based on the promise of revenue. For example, a municipal bond that’s issued to raise money for a new hospital.
Key Points
• Secured bonds have collateral backing, reducing risk for investors, while unsecured bonds rely on the creditworthiness of the issuer.
• Secured bonds may be backed by physical assets or income streams, such as mortgage bonds or revenue bonds.
• Unsecured bonds, like U.S. Treasury Bonds, depend on the issuer’s creditworthiness and are riskier than secured bonds.
• Secured bonds offer the benefit of potential collection from issuer assets in case of default, but the process can be complex.
• Investors should consider their risk tolerance and goals when choosing between secured and unsecured bonds for their portfolios.
What Are Secured Bonds?
A secured bond is one that has an asset as collateral to back up a person’s investment. This asset can be something physical, such as a piece of property or equipment, or an income stream. A government agency might issue bonds to raise money to build a bridge, which is a common example of how bonds work.
In the government bridge-building example, the bonds could be secured — but, in this case, not by the bridge itself; rather, by the future revenue stream that will be generated after construction is complete when a toll will be charged for people to drive over that bridge.
This type of bond can sometimes be referred to as a revenue bond. These are often considered non-resource — meaning that, if the source of revenue dries up, the investor often doesn’t have an ability to get paid.
And a bond can actually be secured by both a physical asset and an income stream. An example of bonds that are secured by both is a bundle of mortgage loans. This has the physical property being mortgaged by borrowers as collateral, as well as the income stream that comes in when people make their mortgage payments.
A key benefit of choosing a secure bond is that, if the entity issuing the bond defaults on making payments to bond purchasers, then the investors can attempt to collect from the assets of the issuer to get their money.
The process isn’t necessarily as straightforward as an investor owning or buying bonds in default might like, however, in part because the collateralized assets may not be significant enough in worth to cover the totality of what’s owed — and in part because issuers may challenge the investors’ right to those assets. So, in reality, it can take weeks to months, or even longer, to actually get bond-related money from an issuer in default.
Investors who want to purchase secured bonds typically seek them out from corporations and municipalities. That doesn’t mean, however, that all corporate bonds are secured; in fact, many of these types of bonds are in fact unsecured.
💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.
What Are Unsecured Bonds?
Unsecured bonds are those that don’t have assets backing them. Instead, investors are given the “full faith and credit” of the entity issuing them that the bonds will be paid upon, as promised. U.S. Treasury Bonds, for example, are considered unsecured (although these are also considered one of the lowest risk investments available).
If the issuer of an unsecured bond defaults, owners of these bonds would still have a claim on the issuer’s assets, but are paid only after holders of secured bonds are paid.
From a risk and return perspective, it might seem as though secured bonds present a lower risk because they have collateral behind them. There may be some truth to that, but investors wanting low risk often buy Treasury bonds — unsecured investments — because the U.S. government has made all scheduled payments over the past 200+ plus years.
When choosing what bonds to buy, here’s guidance: as a generalization, debt that’s considered riskier will offer more attractive interest rates. Those backed by entities with strong economic profiles will have relatively lower rates. And, although “secured” sounds more reliable than “unsecured,” the reality is that a secured bond of “junk” quality is actually riskier than an investment grade unsecured bond.
A person’s goals when investing, including when choosing bonds, should help to guide which ones make sense to purchase.
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Secured vs Unsecured Bonds
There are pros and cons to investing in both secured and unsecured bonds. Investors would be wise to take everything into consideration. Here’s a quick look at the pros and cons
|
Secured vs. Unsecured Bonds: Pros |
|
|---|---|
| Secured bonds | Unsecured bonds |
| Security | Potential for higher returns |
| Low default risk | May be more choices on the market |
| Good diversification assets | May be a good middle-ground investment for less risk-averse investors |
|
Secured vs. Unsecured Bonds: Cons |
|
|---|---|
| Secured bonds | Unsecured bonds |
| Subject to interest rate risks | Higher-risk |
| Not completely risk-free | More volatile |
| Lower potential returns | Subject to interest rate risks |
Benefits of Investing in Bonds
In general, investing in either secured or unsecured bonds can have some benefits. Namely, that they provide a source of income, and can reduce portfolio volatility to certain degrees. But there are some differences, too.
Benefits of Investing in Secured Bonds
Bonds pay a fixed interest rate, typically paying investors twice a year, which creates the income that a bond holder may want. Plus, because they are typically lower in risk than stocks, they can help to reduce the overall levels of risk in an investor’s portfolio.
Because a person’s risk tolerance plays a significant role in the type of investing that is best for them, investors can determine their risk tolerance as a way of analyzing the degrees of risk that feel comfortable for them. Again, secured bonds are among the safest investments out there — but they’re not completely risk-free.
Benefits of Investing in Unsecured Bonds
The main benefit of investing in unsecured bonds versus secured bonds is the potential for higher or better returns. Since unsecured bonds are riskier, there’s a potential for higher rewards — the old adage is true, that there’s a correlation between risk and reward.
While unsecured bonds aren’t the riskiest investment on the market, they tend to be riskier than their secured counterparts.
How Bonds Factor Into Asset Allocation
Savvy investors typically create diversified portfolios, which contain a mix of assets, often including stocks and bonds with varying levels of risk and reward.
Diversification is the financial version of not putting all eggs in one basket, with asset allocation referring to the amount of money invested into each type of asset class within a person’s portfolio.
Individual investors can each decide what asset allocation makes the most sense for them, perhaps including 60% stocks and 40% bonds, as just one example.
Factors involved in determining asset allocation include an investor’s
• Financial goals
• Risk tolerance
• Investing timelines (when retirement is looming, for example, asset allocations may be different than for a younger investor)
By looking at these factors, along with possible investment options and their historical performances, an investor can choose a mix of assets that seem to dovetail best with his or her unique goals, challenges, and overall financial situation.
💡 Quick Tip: How to manage potential risk factors in a self-directed brokerage account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.
Asset Allocation Models
There are four broad asset allocation models that can be shared to show varying investment strategies. Some, but not all of them, typically include bonds.
Capital Preservation Portfolio
As the name suggests, an investor creating this type of portfolio wants to preserve capital, and is averse to losing money, even short term.
This can be the type of portfolio created for investors who have short-term goals (meaning, those intended to be accomplished within one year), such as someone building an emergency fund, or saving to buy a car. Investors with capital preservation goals might put an entire portfolio in a money market fund because stocks and bonds alike can have short-term losses.
Income-producing Portfolio
Investors using this strategy typically focus on generating income, rather than portfolio growth, often because they will be living off investment income to some degree. For example, someone who is already retired might invest in income producing vehicles to supplement a monthly pension.
This person’s portfolio might include bonds, whether secured or unsecured, from government entities or corporations with a history of steady profitability. Other elements of the portfolio might include shares of stocks that pay dividends and/or real estate investment trusts. Investing in I bonds is another possibility.
Growth Portfolio
As a third investment model, a growth strategy can be chosen by people who want long-term portfolio growth. These investors may be willing to take more risk than those who fit into one of the two previous models described if they believe they can receive higher returns.
This investor may still be working and therefore not need to have their portfolios generate income yet. A portfolio focusing on growth may largely or even fully have stock investments.
Balanced Portfolio
This type of portfolio can be a blend of an income-producing and a growth portfolio. People of all ages along the investment journey may choose to use a balanced approach to manage portfolio volatility, and this type often contains a mix of common stocks with investment-grade bonds.
This type of portfolio, in other words, is created to balance assets that grow over time with less volatility with those that can produce growth.
Stock and Bond Allocation “Rule”
Financial professionals sometimes use formulas to determine the best mix of stocks and bonds in a portfolio for an investor. One such “rule” is to subtract the investor’s age from 110.
The number that remains may indicate the percentage of a portfolio that should go into buying stocks. So, while a 30 year old may use this to put 80% of funds into stocks, a 60 year old — using the same formula — would put in only 50%.
The remainder could be invested into a more conservative choice: bonds. Because different people have different risk tolerances, this is not a hard and fast rule; rather, it’s a starting point when deciding how aggressive or conservative an investor wants a portfolio to be.
💡 Recommended: Conservative Investing Explained
The Takeaway
Secured bonds and unsecured bonds differ in one key way: One is secured by collateral, and the other is not. That plays a role in how risky each type of bond is, and thus, can inform an investor’s strategy. Both types of bonds may have a place in an investor’s portfolio.
Portfolios may be rebalanced more often if an asset class experiences a significant change, with the goal always being to keep an investor’s portfolio on track with stated goals. Bonds of all types can be a part of that, but it may be best to consult with a financial professional for advice.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
FAQ
What is the difference between secured bonds and unsecured bonds?
The main difference between secured bonds and unsecured bonds is that secured bonds are secured by collateral, whereas unsecured bonds are more or less dependent on the issuers’ creditworthiness.
What does it mean when a bond is secured?
A secured bond refers to the fact that the issuer of the bond has put up some sort of collateral. In that case, the bonds are less risky, because if the issuer defaults, the collateral can be sold to pay back bondholders.
What is the purpose of an unsecured bond?
Unsecured bonds allow companies or organizations to borrow money without putting up any collateral – which can be extremely helpful if they don’t have any. That makes them riskier, however, than secured bonds.
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