An unsecured bond is a debt security that is not guaranteed by collateral, such as equipment or revenue, of the issuer. In some cases, the issuer might not be able to collateralize due to a lack of assets, so any issued bonds are backed only by a promise to repay the borrowed money. Typically, an unsecured bond is classified as either a straight debenture or a subordinated debenture. Investors should fully understand the risks involved with these types of bonds, including the risk of default, before investing in them.
In general, a bond is a security issued by a corporation or government in order to borrow money. It is often used to raise capital for expenses and to buy equipment. This form of debt security usually has a fixed interest rate that is set at the time of origin by the issuer. Thus, the issuer agrees to pay interest to the bondholders and promises to repay the full amount borrowed upon the maturity date.
One type of unsecured bond is a debenture. It is backed by the general credit of the issuer, and the owner of a debenture is considered a creditor of the issuing company. In the event that the issuer liquidates, straight debenture owners have priority on claims over those of subordinated debentures, although secured bond owners are paid first.
Another kind of unsecured bond is called a subordinated debenture, which is junior in claims to straight debentures. This type of unsecured bond is riskier than straight debentures and secured bonds, but it offers greater income potential through higher interest rates. Examples include high-yield bonds and junk bonds, which have a high risk of issuer default. Due to the increased risk, junk bonds generally have raised expenses and costs, and in many cases, mutual funds that hold junk bonds will pass the expenses to the investors.
An example of an unsecured bond is a United States Treasury bond, which is backed by the faith and credit of the government rather than collateral. If necessary, the government can raise taxes or take other measures to increase revenue to repay the bonds. Since there is little chance of default, this type of bond is considered to be fairly low risk.
Investors should be aware of the various risks associated with an unsecured bond before investing in it. One of the greatest risks with this type of bond is credit or default risk, which is the possibility that the issuer will default on the loan and be unable to repay the amount at maturity. Another possibility is interest rate risk in which the bond price decreases as interest rates rise. Additionally, an unsecured bond with a fixed interest rate is subject to inflation risk, which occurs when the interest rate of the bond does not keep up with the inflation rate. It is recommended that investors thoroughly read the prospectus for a security prior to purchase.
