Unsecured bond is defined as the capability of a customer to obtain goods andfacilities before payment, with the belief that the payment will be done in the near future. Unsecured bonds are also called debentures, and they are not backed by revenue, equipment or any mortgages on real estate. Instead, a promise is made by the issuer that they will be repaid. This promise is called ‘full faith and credit’. It can also be defined as a type of debt certificate which requires a fixed rate of interest or annual sum till maturity.
Why issue unsecured bonds?
Normally, some of the companies do not have many assets with themselves to collateralize. Whereas other companies are established and hence trusted to repay their debts. In case of governments, they can always increase their taxes if they need to pay their shareholders. Unsecured bonds, in general, carry a higher risk than the secured bonds. As a result, unsecured bonds pay a higher rate of interest than the secured bonds. If a company that issues debentures liquidates, then it pays the holders of the secured bonds first, then the debenture holders and lastly the owners of the subordinated debentures.
Types of unsecured bonds
The various types of unsecured bonds are:
1. Treasury bonds - It is a debt instrument with a maturity of 10 years or longer. These types of bonds are considered very safe in terms of default and are very much popular among the investors.
2. General obligation bonds - These are also called municipal bonds without backing. The only security, that one delivers is the credit worthiness of the issuing city or state. These bonds also finance municipal operations.
3. Income bonds - In this type of bonds, the payments are made only after a certain amount of income is earned by the issuer. The investor may be willing to invest in this type of bond only if the coupon rate is attractive, or there is a high yield to maturity as he is aware of the risks involved.
4. Convertible bonds - These types of bonds gives the option to an investor to convert the bonds into shares of common stock. At the time when the bonds are issued, the conditions, price and the time frame must all be set down.