What are Collateral Trust Bonds?

Collateral trust bonds are a special kind of bond. Companies sell them to borrow money. But they’re different from most bonds in a significant way.

You see, when a company sells a regular bond, they’re promising to pay back the money to the bond buyers later on. The company gets cash now and the bond buyers are supposed to get their money back in the future, with some extra cash called interest.

But with collateral trust bonds, an extra layer of security is involved. The company that’s selling the bonds – they’re called the “issuer” – takes some of their valuable assets and uses them as a guarantee. They still own those assets. But if something goes wrong and the company can’t pay back the bonds, the bond buyers get to take those assets instead.

The Assets Used as Collateral

The assets the company uses to back up the collateral trust bonds – that’s the “collateral” part – it’s usually a mix of different stuff the company owns. Could be stocks, could be bonds from other companies, could even be cash sometimes. Together, all those assets are called a “portfolio.”

The important thing is, the company keeps that portfolio on their own books. If you look at their balance sheet, which is just a record of what a company owns and owes, you’ll see that portfolio of assets listed right there. The bond buyers don’t own it, even though it’s being used as collateral.

How It’s Different From Pass-Through Securities

Now, collateral trust bonds might sound kind of like another type of bond called a pass-through security. But they’re actually pretty different.

With pass-through securities, the assets used as collateral get taken off the company’s balance sheet completely. The bond buyers sort of own them together in a separate legal setup. Any money those assets make gets “passed through” to the bond buyers.

But like we said, with collateral trust bonds, the company keeps the assets. They still own them, and any money the assets make belongs to the company, not the bond buyers. The assets are just there as a backup in case the company has trouble paying back the bonds.

Why Companies Use Collateral Trust Bonds

Companies like to use collateral trust bonds for a few reasons.

They’re Secured Debt

First off, because the bonds are backed by assets, they’re what’s called “secured debt.” That makes them a bit less risky for bond buyers compared to “unsecured” bonds that aren’t backed by collateral.

Less risk for buyers usually means the company can offer a lower interest rate on the bonds. Lower interest is good for the company because it means their borrowing costs are lower. They don’t have to pay back as much extra money on top of what they borrowed.

Assets Stay on the Balance Sheet

Companies also like that they get to keep the assets on their own balance sheet with collateral trust bonds. It makes their financial picture look better compared to pass-through securities.

Why? A couple reasons. One, the company’s balance sheet looks bigger because they still have all those assets listed as stuff they own. Bigger can look better to people studying the company’s finances.

Two, if the assets in the collateral portfolio are making money, the company gets to count that money as income. With pass-through securities, that money goes straight to the bond buyers instead. Companies like keeping that income for themselves.

More Financial Flexibility

The way collateral trust bonds are set up also gives companies a bit more wiggle room financially.

They might be able to swap out assets in the collateral portfolio if they need to. As long as the value of the portfolio stays the same, the bond terms might let them trade one type of asset for another.

And if the company wants to sell off assets for cash, they can do that more easily with collateral trust bonds. The assets aren’t tied up in a separate legal entity like with pass-through securities. The company has more control.

Risks for Bond Buyers

Of course, collateral trust bonds aren’t perfect. Bond buyers face some risks.

Company Could Still Default

The big one: the company could still default. That’s when they can’t make their promised payments on the bonds.

Yes, the bonds are backed by collateral. But that doesn’t mean the company absolutely can’t default. If their financial situation gets bad enough, they might have to.

And even though bond buyers can go after the collateral assets if a default happens, they might not get all their money back. It depends on what the assets are worth at that point. There’s no perfect guarantee.

Value of Collateral Could Fall

That’s the other big risk – the value of that collateral portfolio could drop. The assets are supposed to be high-quality, but their market prices can still fall.

If that happens, the collateral might not fully cover what bond buyers are owed. The cushion of security gets thinner. Not great for bond buyers.

Due Diligence is Key

Because of those risks, bond buyers have to do their homework with collateral trust bonds.

They need to really dig into the specific assets being used as collateral. What exactly is in that portfolio? How stable are the values? How easily could the assets be sold off if needed?

Bond buyers also have to make sure they understand the exact legal terms of the bond. When can the company make changes to the collateral? What has to happen for bond buyers to take control of the assets? It gets tricky.

A good bond buyer is going to sift through all the details before they hand over their cash. They’ll likely get financial and legal advisors to help.