Secured and unsecured bonds form two different classes of fixed-income securities that primarily vary according to risks and returns. For investors looking to invest in bonds in India, understanding how they work could make a big difference. In this article, you will get to know about all the differences and how NCDs come into this equation and help you decide which one is suitable for you.
What are Secured Bonds?
Secured bonds are debt instruments that have backing or support from certain assets that belong to the issuer. The assets may include properties, receivables, plant and machinery, or infrastructure projects. In case of default, the investors have a right to recover from these assets.
In India, infrastructure bonds issued by organisations such as NHAI are examples of secured bonds. Mortgage securities also come under this type of debt instrument. The risk is less for investors, and hence, they may receive slightly lower interest on secured bonds than unsecured ones.
This is suitable for conservative investors, and here, investors' safety is more important than returns.
What are Unsecured Bonds?
Unsecured bonds are also referred to as debentures. In the case of unsecured bonds, there is no specific collateral attached. The trust of the investors in the bond issuer is purely based on the financial condition of the issuer. There is no specific asset to look forward to in the event of default by the issuer.
Since the risk factor is on the higher side, the issuer has to offer higher returns to the investors. This makes the bond attractive to investors willing to take up the risk in return for higher returns.
It is also important to note that in the event of liquidation, the unsecured bondholders are settled after the secured bondholders. This is referred to as the 'liquidation waterfall.' This clearly indicates the priority of the bondholders. Credit ratings are of vital importance in the case of unsecured bonds. A low-rated issuer of unsecured bonds must be dealt with caution.
Key Differences Between Secured and Unsecured Bonds
The table below gives you a quick view, but the real difference shows during a credit event or default, which is when the presence or absence of collateral becomes very crucial.
Feature | Secured Bonds | Unsecured Bonds |
Collateral | Backed by specific assets | No collateral |
Risk Level | Lower | Higher |
Interest Rate | Lower | Higher |
Recovery on Default | Better chances | Lower priority |
Dependence on Credit Rating | Moderate | High |
Suitable For | Conservative investors | Risk-tolerant investors |
Secured vs Unsecured NCDs in India
Non-Convertible Debentures (NCDs) are one of the most common bond instruments available to investors in India. They are of two types: secured and unsecured.
- Secured Non-Convertible: Debentures are backed by the assets of the company. The rules set by the SEBI are that the assets should be at least one time the outstanding Non-Convertible Debentures at all times. This provides investors with a level of protection in case the company faces financial difficulties.
- Unsecured Non-Convertible: Debentures are backed by the creditworthiness of the company. They are not backed by any assets of the company. This makes them purely dependent on the financial health of the company.
The rules set by the SEBI are that the issuer must disclose in the prospectus and other documents accompanying the issue of Non-Convertible Debentures if the Non-Convertible Debentures are secured or unsecured. This is one aspect that every investor should be aware of before investing in these debt instruments.
It has also been seen that investors prefer to invest in secured Non-Convertible Debentures, but investors with higher risk tolerance also look to invest in Unsecured Non-Convertible Debentures if the yield is attractive enough.
Pros and Cons of Each Type
Here are some advantages and disadvantages of secured and unsecured bonds
Secured Bonds
Advantages:
- Lower risk due to asset backing
- Better recovery prospects if the issuer defaults
- More suitable for capital preservation
Drawbacks:
- Lower interest rates compared to unsecured bonds
- Returns may not beat inflation by a wide margin
Unsecured Bonds
What works in your favor:
- Higher interest rates
- Can add meaningful yield to a fixed income portfolio
What you give up:
- Higher default risk
- No asset to fall back on
- Heavily dependent on issuer's credit quality and financial discipline
Neither type is universally better. The choice between the two types of bonds depends on what you are trying to accomplish and how much uncertainty you are willing to live with.
Which Type of Bond is Right for You?
It depends on your personal financial goals and risk perception. If you’re more focused on capital safety, secured bonds may be a better option for you. While you’re sacrificing some interest, you’re essentially paying for the security that there is an asset backing up this investment.
On the other hand, if you’re more willing to take on credit risk and you’re looking for better returns, unsecured bonds from highly rated issuers may be a better option for you. However, you should be careful to look at credit ratings for these bonds and only invest in them if they have a rating of at least AA.
Diversification across secured and unsecured bonds may be a more practical and feasible option for investors.
It is important to note that investing in bonds in India is not without complexities and risks. Credit risk in fixed-income investments is a key challenge.
Conclusion
Secured and unsecured bonds have different functions in a fixed-income portfolio. Secured bonds provide greater security and are more appropriate for investors who prefer security. Unsecured bonds have greater risks but may provide better returns if the issuer is financially strong and has a high credit rating. A careful assessment is thus critical to improve your bond portfolio without increasing risks.
FAQs on Secured and Unsecured Bonds
1. What is the main difference between secured and unsecured bonds?
The fundamental difference is that secured bonds are backed by assets that can be used to recover money in case of default. Unsecured bonds are not backed by any assets and depend on the ability of the company to pay its dues.
2. Are unsecured bonds too risky for retail investors?
Unsecured bonds issued by companies with high ratings (AA and AAA) are relatively less risky for retail investors. The risk lies in investing in unsecured bonds of companies that have poor ratings and are unrated.
3. Which type of bond offers higher returns?
Unsecured bonds offer higher interest rates compared to secured bonds because of the higher risk involved. The difference in yield between secured and unsecured bonds of the same company can be anywhere from 0.5 to 2%.
4. Are NCDs in India secured or unsecured?
NCDs in India can be either secured or unsecured. According to SEBI, it is mandatory for all issuers to specify in their offer documents whether they are issuing secured or unsecured NCDs.
5. What happens if a bond issuer defaults?
In case of a secured bond, the issuer defaults and goes into liquidation, and the assets that were mortgaged will be sold to settle the debt. In case of unsecured bonds, investors are repaid along with other creditors.
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