Mortgage bonds are the first type of secured (collateralized) bond we’ll discuss in detail. When a corporation issues a mortgage bond, they pledge real estate as collateral for the bond. Examples of specific collateral include factories, equipment, and corporate real estate.
Issuers sell mortgage bonds as a way to lower their overall cost of borrowing money. If an issuer sells debentures, investors take on more risk with no collateral and demand higher interest rates. By pledging real estate, the issuer can easily lower their interest rate but will lose their property if they cannot pay off the bond.
Utility companies are common issuers of mortgage bonds. Many times, these organizations own significant amounts of valuable property that offer them a quick and easy way to secure their bonds. Utility companies often issue mortgage bonds backed by factories, electrical grids, and power plants.
First mortgage bonds relate to priority if liquidation of the collateral occurs. Assume an issuer of mortgage bonds is unable to repay interest and principal to its bondholders. In this case, the company is forced to liquidate (sell) the real estate collateral backing the bond. First mortgage bondholders receive the proceeds of the sale first, until they’re made whole. After, any leftover proceeds are sent to investors in second mortgage bonds. Because they’re lower on the priority scale, second mortgage bonds are riskier, trade at lower prices in the market, and provide higher yields to their investors.
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