Understanding Collateralization and Defaults

In the event a corporation goes out of business or defaults on its debt, bondholders, as creditors, have priority over stockholders in bankruptcy court. However, the order of priority among all the vying groups of creditors depends on the specific terms of each bond, among other factors.

If a company is liquidated, bondholders usually have priority over stockholders in a company’s capital structure and are more likely to receive payment. The percentage of funds received through liquidation compared with the original investment is called the “recovery rate.” One of the most important factors in the recovery rate is whether the bond is secured or unsecured. If a bond is secured, the issuer has pledged specific assets (known as collateral) that can be sold, if necessary, to pay the bondholders. Investors buying a secured bond will “pay” for this extra protection by receiving a lower interest rate than would be received on a comparable unsecured bond.

As the table below shows, the holders of “secured debt” and “unsecured senior debt” have the highest claim on corporate assets in a bankruptcy distribution. Even the holder of a low-rated bond is entitled to a share of a failing company’s assets ahead of preferred or common stockholders.

Priority of Claims

  1. Secured Debt Holders
  2. Unsecured Senior Debt Holders
  3. Other Unsecured Subordinated Debt Holders
  4. Preferred Stockholders
  5. Common Stockholders

Debentures. Most corporate bonds are debentures — that is, unsecured debt obligations backed only by the issuer’s general credit and the capacity of its cash flow to repay interest and principal. However, even unsecured bonds usually have the protection of what is known as a “negative pledge provision.” This requires the issuer to provide security for the unsecured bonds in the event that it subsequently pledges its assets to secure other debt obligations.

Mortgage bonds. These are bonds for which real estate or other physical property has been pledged as collateral. They are mostly issued by public utilities.

There are various kinds of mortgage bonds, including: first, prior, overlying, junior, second, third, and so on. The designation reflects the priority of the lien, or legal claim, against the specified property. Investors should consider how much other debt of the issuer is secured by the same collateral, and whether the lien supporting that other debt is equal or prior to a bond’s lien when evaluating and investing in mortgage bonds.

Collateral trust bonds. A corporation may deposit stocks, bonds, and other securities with a trustee to back its bonds. The collateral must have a market value at the time of issuance at least equal to the value of the bonds.

Equipment trust certificates. Railroads and airlines are examples of companies that issue this type of bond as a way to pay for new equipment at relatively low interest rates. The title to the equipment is held by a trustee until the loan is paid off, and the investors who buy the certificates usually have a first claim on the equipment.

Subordinated debentures. Debt that is subordinated, or junior, has a lower priority than that of other bond-debt in terms of payment. Only after secured bonds and debentures are paid off can holders of subordinated debentures be paid. In exchange for this lower status in the event of bankruptcy, investors in subordinated securities earn a higher rate of interest than is paid on senior securities.

Guaranteed bonds. Another form of security is a guarantee of one corporation’s bonds by another corporation. For example, bonds issued by a subsidiary may be guaranteed by its parent corporation, or bonds issued by a joint venture between two companies may be guaranteed by both parent corporations. Guaranteed bonds become, in effect, debentures of the guaranteeing corporation, and benefit from its presumably better credit quality.


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