Mortgage bonds

Mortgage bonds are a common type of secured (collateralized) bond. When a corporation issues a mortgage bond, it pledges real estate as collateral for the bond. Examples of collateral include factories, equipment, and other corporate real estate.

Issuers use mortgage bonds to reduce their overall cost of borrowing. If an issuer sells debentures, investors have no collateral to fall back on, so they take on more risk and typically demand higher interest rates. By pledging real estate, the issuer can usually borrow at a lower interest rate. The trade-off is that if the issuer can’t make the required interest and principal payments, it can lose the pledged property.

Utility companies are common issuers of mortgage bonds. These companies often own large amounts of valuable property, which makes it relatively straightforward to secure their bonds. For example, a utility company might issue mortgage bonds backed by factories, electrical grids, and power plants.

First mortgage bonds describe who gets paid first if the collateral has to be sold. Suppose an issuer can’t repay interest and principal to its bondholders. The company may be forced to liquidate (sell) the real estate collateral backing the bond. First mortgage bondholders receive the sale proceeds first, up to the amount they’re owed. Any remaining proceeds then go to investors in second mortgage bonds. Because second mortgage bonds have a lower claim on the collateral, they’re riskier, tend to trade at lower market prices, and typically offer higher yields.