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Asset or Collateral Backing
#fixed #income

3.1.3. Asset or Collateral Backing

Collateral backing is a way to alleviate credit risk. Investors should review where they rank compared with other creditors in the event of default and analyze the quality of the collateral backing the bond issue. Seniority Ranking

Secured bonds are backed by assets or financial guarantees pledged to ensure debt repayment in the case of default. In contrast, unsecured bonds have no collateral; bondholders have only a general claim on the issuer’s assets and cash flows. Thus, unsecured bonds are paid after secured bonds in the event of default. By lowering credit risk, collateral backing increases the bond issue’s credit quality and decreases its yield.

A bond’s collateral backing might not specify an identifiable asset but instead may be described as the “general plant and infrastructure” of the issuer. In such cases, investors rely on seniority ranking—that is, the systematic way in which lenders are repaid in case of bankruptcy or liquidation. What matters to investors is where they rank compared with other creditors rather than whether there is an asset of sufficient quality and value in place to cover their claims. Senior debt is debt that has a priority claim over subordinated debt or junior debt. Financial institutions issue a large volume of both senior unsecured and subordinated bonds globally; it is not uncommon to see large as well as smaller banks issue such bonds. For example, in 2012, banks as diverse as Royal Bank of Scotland in the United Kingdom and Prime Bank in Bangladesh issued senior unsecured bonds to institutional investors.

Debentures are a type of bond that can be secured or unsecured. In many jurisdictions, debentures are unsecured bonds, with no collateral backing assigned to the bondholders. In contrast, bonds known as “debentures” in the United Kingdom and in other Commonwealth countries, such as India, are usually backed by an asset or pool of assets assigned as collateral support for the bond obligations and segregated from the claims of other creditors. Thus, it is important for investors to review the indenture to determine whether a debenture is secured or unsecured. If the debenture is secured, debenture holders rank above unsecured creditors of the company; they have a specific asset or pool of assets that the trustee can call on to realize the debt in the event of default.

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