Noncovered security

Noncovered security
See also

Noncovered security is an investment of any kind where the investor has no guarantee of payment of interest due and redemption (G. G. Fuster, et al., 2011, pp. 5). In the theory of finance, the risk of the buyer of these bonds is higher, therefore, they should have a higher interest rate. However, this rule does not always translate into practice (G. G. Fuster, et al., 2011, pp. 5).

The essence of noncovered security

To begin with, it is worth explaining the reasons for issuing this type of security. Noncovered securities are usually issued by financially sound entities, but this is not the rule (V. Pandey, D. Pandey, 2012, p. 46). Sometimes an unsecured issue results from the fact that a given entity does not have assets that would be an adequate security, due to the nature of its activity (e.g. IT companies or companies operating in the loan industry) (V. Pandey, D. Pandey, 2012, p. 46). Another problem is the fact that the security may cause an increase in debt service costs. This is the case when the assets are not owned by the issuer but leased (V. Pandey, D. Pandey, 2012, p. 46). It also happens that securities are partially secured, but even in such a case they are classified as unsecured. This is because only entities whose issue is fully secured can use the term 'collateralised'. Therefore, it is worth looking carefully at the company's offer documents in order to verify whether noncovered security actually does not involve a slightly lower risk than one might think (V. Pandey, D. Pandey, 2012, p. 48).

Benefits of noncovered security

As regards the benefits of noncovered security, they are normally expected to bear a higher interest rate than covered bonds. However, this rule is often not respected when the issuer of the bond is a well-established and financially sound entity. Investor confidence in the issuer plays an important role. In relation to smaller entities, however, the impact of the collateral issue on the interest rate, and thus the costs of debt service for the issuer can already be seen (P. Bank, et al. 2016, pp. 12-15).

Noncovered security and the bankruptcy of the issuer

Another issue related to the purchase of unsecured bonds is the issue of a share in the assets of an issuer in the event of its bankruptcy. At this level, unsecured bonds are much worse off than unsecured bonds. The bondholders' claims are satisfied as the last but one, so the chances for the return of all or at least a significant part of the invested funds are negligible (P. Bank, et al. 2016, pp. 12-15). In accordance with the principle of priority, the assets are allocated to the following groups in turn (I. Otterbach, et al. 2006, pp. 173-174):

  • costs of bankruptcy proceedings
  • salaries for employees.
  • taxes
  • other claims (bondholders belong to this category)
  • interest

In the case of the repayment of Category I to III creditors, where the amount of the insolvency assets is insufficient to repay the bondholders in full, and only in part, the administrator of the insolvency assets shall distribute the assets in accordance with the principle of proportionality. This is a significant disadvantage compared to covered security, where claims are satisfied by collateral (I. Otterbach, et al. 2006, pp. 182 ).

Noncovered security and risk

There are many examples of unsecured bond investments with a lower risk than bond investments. What is important is that, in the case of unsecured bonds, the issuer is liable for these obligations with all its assets (D. Becherer, T. Bilarev 2018, pp.451-455). When a liquidation company is declared bankrupt, the bondholders are satisfied in the order specified in the Bankruptcy and Reorganisation Law. In the case of secured bonds, the object of the collateral shall be enforced (D. Becherer, T. Bilarev 2018, pp.451-455). The basis for the analysis of bond risk should be the issuer's financial standing, balance sheet structure and business model. The collateral should be an additional element of the analysis, not its main factor. From a practical point of view, a much safer investment variant seems to be covered by bonds. However, in reality, the choice is not so simple and should be made only after a reliable verification of the issuer's financial situation. It is better to invest in unsecured bonds of a profitable entity than in secured securities of a potential bankrupt (D. Becherer, T. Bilarev 2018, pp.451-455).

References

Author: Dawid Misiura

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