Posted on May 16, 2019
Secured bonds, also referred to as senior secured bonds, are a great way to get decent bond yields while having extra protection against the risk of default. Any rational investor would choose a secured bond over an unsecured bond if the yields were comparable. However, investing in secured bonds can be problematic as they are difficult to find. Most bond issuances are not traded often and are not secured. Even worse is the prospect of investing in secured bond ETFs as these are generally limited to senior bank loans which have high credit risk and diluted recovery covenants. However, investing in senior secured bonds is not impossible and the investor can be rewarded for doing a little legwork. Here is how to do it.
Secured bonds are typically senior bonds that are secured by physical assets owned by the issuing company. If the issuing company where to default on a secured bond, the assets backing the bond will be sold and the proceeds will be available to the bond holders. Secured bonds outrank other types of debt instruments and can be either investment grade or junk.
Since the large majority of bonds available to retail investors are senior unsecured bonds it makes sense to compare secured bonds to unsecured bonds. Senior secured bonds are less risky than senior unsecured bonds with comparable yields. Moody's shows the average recovery rates over the 1983-2017 period of senior secured bonds was 53.62% compared unsecured senior bonds of 37.74% as illustrated below.
You may have noticed that first lien secured bond recovery rates are higher than second lien secured bonds, even though second lien secured bond recovery rates are still higher than unsecured bonds. You may also have noticed that bank loans have even higher recovery rates than all other types of debt. However, don't be fooled as this will most likely not continue to be so. Central banks all over the developed world have been warning the markets about the increased risks in these types of loans. Namely, the market size of senior bank loans has increased dramatically to well over $1 trillion in outstanding loans. Even worse is the estimation of roughly 80% of bank loans being "covenant lite" loans, meaning typical restrictions do not exist that cap leverage and collateral within lenders' reach is limited.
The risks of investing in secured bonds is the risk the bond issuer can't repay the loan - otherwise known as default risk. Note this risk is not any different than a traditional senior unsecured bond. If anything, the risk is lower since investors recoup more principle for secured bonds than unsecured bonds. However, credit ratings do indeed matter. Since the recovery rate of secured bonds is not 100% that means credit risk needs to be evaluated. In other words, don't go out and blindly buy secured bonds without reviewing the credit rating of the issuer.
Let's get started! Head over to the Financial Industry Regulatory Authority's bond center search page located here.
Click the 'search' tab and then click the 'show' link next to the advanced search section:
Under the bond seniority drop down box select 'senior secured' and then click 'show results' button. You may want to input a maturity date as well if you want to exclude short or long-term bonds.
From here you get a listing of all senior secured corporate bonds. You can sort the list however you want, be it by maturity, yield, credit rating, etc. If you find the list is too long to effectively review you can add in more filters to the search.
If you click on a given bond you will get more specific details. I'll run threw an example of a bond to illustrate the important areas and what to do next. I picked the following senior secured bond:
I boxed off in red the most relevant information. The bond is callable but not until 2014. The most recent price and yield are stated as well as the maturity date. Note the bond is defined as a high yield bond due to the Moody's rating of Ba1 (although Standard & Poor's rating of BBB- is investment grade).
Take note of the prospectus link. Just because this bond shows up as a senior secured bond does not make it so. Read the prospectus to make sure it is a first lien loan backed by collateral worth something. I looked at the bond's prospectus and found it to be a first lien bond backed by pledged securities, intercompany obligations and additional collateral. I also found the loan was a floating interest rate even though this information was not displayed in the bond details.
I'll use Fidelity as an example to trade bonds since I use them as my bond broker. However, it will be the same steps as any brokerage firm. Navigate to the Fidelity bond search page, enter in the CUSIP and click the search button:
We found it! The bond is at an ask price of $104.668 per bond with a yield to worst of 3.399%. The minimum quantity needed to buy at this price, as defined by the seller, is two bonds. In other words you can buy anywhere from two to ninety-nine bonds immediately for $104.668 per bond.
The most common problem you'll find when trying to buy secured bonds is the fact that many of them do not trade activity. Even if you find a desirable secured bond, odds are there will not be a sell order open to buy against. This problem applies to all bonds however and not just secured bonds.
Another problem is the need to research each individual bond to identify the specific collateral involved and the relative ranking of the loan (e.g. first or second lien) as these characteristics are not easily expressed in the data.
These problems can be annoying and frustrating at times but that is the necessary cost if you want to invest in secure bonds. I suggest the following sequence to reduce frustration:
Although sometimes troublesome and frustrating, investing in secured bonds can be rewarding through comparative yields versus unsecured bonds and less comparative risk. I hope this guide helps you increase your risk-adjusted returns periods ahead.