Companies and governments are always in need of funds. To raise these funds, they often turn to equity and debt instruments. Equity financing involves selling an interest in the company while debt financing involves borrowing money and then repaying it with interest.
Many issuers choose the debt route because it is less expensive than equity and doesn’t require giving up control in the firm to investors. The debt-issuing company (or government) can obtain debt financing by applying for a bank loan. However, this instrument is considered a more restrictive and expensive financing option. A less restrictive and less expensive option is to issue bonds.
A bond is a two-way contract between an issuer and its investors. Issuing a bond with an attractive interest rate enables the issuer to attract investors who have a low risk tolerance and want to earn a regular income from their investable corpus.
Bonds can be either secured or unsecured. How are they different and which one should you invest in? Let’s take a look.
What are Secured Bonds?
Secured bonds are usually issued by smaller companies, although larger corporates and municipalities also issue them. The “secured” means that the bond is backed by an asset or collateral, which could be a physical asset like property or machinery or a liquid asset like stock or revenues.
Investors can claim the underlying asset to recover their investment if the issuing company defaults, thus reducing their risk. However, the low risk also reduces their earnings.
Governments typically issue secured bonds to finance infra projects like bridges, power plants, and dams. For example, in early 2021, Mumbai’s municipal corporation, the BMC announced plans to float a Municipal Infrastructure Bond to raise about Rs. 4,000 crores for large infrastructure projects. Earlier in 2019, the Ahmedabad Municipal Corporation raised Rs. 200 crores by issuing “muni bonds” for infrastructure development. The anticipated revenue that will be generated by these projects is the collateral that secures the bonds.
Government secured bonds are considered very safe investments because they are backed by some specific collateral. However, since they pay lower interest rates, they are mostly favoured by investors who want to protect their capital rather than grow wealth.
What are Unsecured Bonds?
Governments and companies can also issue bonds that are not backed by some underlying asset. They pay a higher interest rate than secured bonds.
However, they also carry a higher risk for investors because they will not be able to recover their investment if the issuer defaults. Nonetheless, unsecured bonds remain an attractive option for some investors because they are often issued by established businesses that investors trust with their money.
Unsecured government bonds are backed by the government’s “full faith and credit”, rather than a specific asset. Therefore, even though investors are not entitled to a particular collateral in case of a (highly unlikely) default, they still get the government’s promise of repayment – not only of interest but also the principal at maturity. This is why unsecured government bonds are still considered a safe investment.
U.S. Treasury Bills (T-Bills) are one of the most well-known unsecured bonds. Although they are not backed by any asset, T-Bills are still considered a low-risk and secure investment because
- They are backed by the U.S. government;
- The government has not missed making a scheduled interest payment or returning the full principal on maturity in 200+ years.
Secured Bonds vs. Unsecured Bonds
So which bond should you invest in?
The answer depends on your financial objectives, investment horizon, risk appetite, and desired returns. Understanding the differences given below can also help you choose the best option for you.
1. Investment Risk, Interest Rates, and Returns
In the bond market, risk, interest rates, and returns go hand-in-hand. Generally, higher risk means higher interest rates and therefore higher returns. Secured bonds are less risky and therefore yield lower returns, while unsecured bonds are riskier and thus promise higher returns.
2. Repayment Guarantee
Since secured bonds are backed by a physical or liquid collateral, they guarantee that you will get your investment back (plus interest), even if the company defaults. No such guarantee is available with unsecured bonds since there is no collateral.
Investor Risk Tolerance
Generally, investors with a low risk tolerance invest in bonds, whether they are issued by corporates or governments. But even within this group, investors with a slightly higher risk tolerance usually choose unsecured bonds. Buyers with the lowest risk tolerance and looking for reliable returns (as opposed to high returns) usually invest in secured bonds.
3. Chances of default
The probability that a larger, well-established bond-issuing company will default is usually very low. Thus, even if their bonds are unsecured, investors almost never lose their money. Smaller, newer, or less stable firms usually issue secured bonds because their risk of default is higher than their larger counterparts.
4. Taxation
In India, the income earned from any bond investment is taxable, whether purchased in a primary public issue, via a bond dealing house, or from the BSE/NSE via a broker. Under the IT Act, the interest earned on bonds is considered “other income” and taxed at 30% plus surcharge and cess. Long-term capital gains (holding period 1+ year) are taxed at 10%.
Suppose you purchase a bond from the primary market for ₹100 with a maturity period of 5 years. But you only hold it for 370 days. On Day 371, you sell it for ₹102. The capital gains here is Rs. 2 and the holding period is over 1 year. So, your coupon of Rs. 2 will be taxed at 10% plus surcharge and cess.
Yubi Invest: Empowering HNIs, Ultra-HNIs, and Wealth Managers with Technology for Easy Bond Investing
In the past, many bond issuances were targeted at institutional investors like commercial banks and corporates. In recent years, these instruments have also become available to individual investors such as HNIs and Ultra-HNIs.
Yubi Invest empowers such investors with cutting-edge technology that simplifies the end-to-end bond investment process. This unified investment platform facilitates trade and investments across various types of bonds available in India, including G-Secs, market-linked debentures, non-convertible debentures (NCDs), sovereign gold bonds, and commercial papers.
Wealth managers and advisors also benefit because Yubi provides unparalleled efficiency through 100% digitisation, 24×7 access to repositories, and actionable insights for all counterparties in the sale. It also provides lightning-fast credit and price discovery plus high liquidity in the secondary market for non-AAA-rated bonds and debentures.
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