What You Need to Know About Secured and Unsecured Bonds for the Series 7 Exam - dummies

What You Need to Know About Secured and Unsecured Bonds for the Series 7 Exam

By Steven M. Rice

For Series 7 purposes, you will need to understand secured and unsecured bonds. Assume that bonds backed by collateral are considered safer for the investor. Secured bonds, or bonds backed by collateral, involve a pledge from the issuer that a specific asset will be sold to pay off the outstanding debt in the event of default. Obviously, secured bonds normally have a lower yield than unsecured bonds.

The Series 7 tests your knowledge of several types of secured bonds:

  • Mortgage bonds: These bonds are backed by property that the issuer owns. In the event of default or bankruptcy, the issuer must liquidate the property to pay off the outstanding bonds.

  • Equipment trusts: This type of bond is mainly issued by transportation companies and is backed by equipment they own (for instance, airplanes or trucks). If the company defaults on its bonds, it sells the assets backing the bonds to satisfy the debt.

  • Collateral trusts: These bonds are backed by financial assets (stocks and bonds) that the issuer owns. A trustee (a financial institution the issuer hires) holds the assets and sells them to pay off the bonds in the event of default.

  • Guaranteed bonds: Guaranteed bonds are backed by a firm other than the original issuer, usually a parent company. If the issuer defaults, the parent company pays off the bonds.

Unsecured bonds are the opposite of secured bonds: These bonds are not backed by any assets whatsoever, only by the good faith and credit of the issuer. If a reputable company that has been around for a long time issues the bonds, the bonds aren’t considered too risky. If they’re issued by a relatively new company or one with a bad credit rating, hold onto your seat!

Again, for Series 7 exam purposes, assume that unsecured bonds are riskier than secured bonds. Here’s the lineup of unsecured bonds:

  • Debentures: These bonds are backed only by the issuer’s good word and written agreement (the indenture) stating that the issuer will pay the investor interest when due (usually semiannually) and par value at maturity.

  • Income bonds: These bonds are the riskiest of all. The issuer promises to pay par value back at maturity and will make interest payments only if earnings are high enough. Companies in the process of reorganization usually issue these bonds at a deep discount. For test purposes, you shouldn’t recommend these bonds to investors who can’t afford to take a lot of risk.

Because secured bonds are considered safer than unsecured bonds, secured bonds normally have lower coupon rates. You can assume that for the Series 7, the more risk an investor takes, the more reward he will receive. More reward may be in the form of a higher coupon rate or a lower purchase price. Either one — or both — lead to a higher yield for the investor.

Check out the following question for an example of how the Series 7 may test your knowledge of the types of bonds.

Jon Bearishnikoff is a 62-year-old investor who has 50 percent of his portfolio invested in common stock of up-and-coming companies. The other 50 percent of his portfolio is invested in a variety of stocks of more secure companies. Jon would like to start investing in bonds. Jon is concerned about the safety of his investment. Which of the following bonds would you LEAST likely recommend?

(A)    Collateral trust bonds

(B)    Mortgage bonds

(C)    Equipment trust bonds

(D)    Income bonds

The answer you’re looking for is Choice (D). This problem includes a lot of garbage information that you don’t need to answer the question. One of your jobs (should you decide to accept it) is to dance your way through the question and cherry-pick the information that you do need.

The last sentence is usually the most important one when answering a question. Jon is looking for safety; therefore, you wouldn’t recommend income bonds because they’re usually issued by companies in the process of reorganizing. As a side note, if you become Jon’s broker, he shouldn’t have 100 percent of his investments in stock. At his age, Jon should have a decent amount of his portfolio invested in fixed-income securities.