Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Unsecured Note

What it is:

In the finance world, an unsecured note is corporate debt that does not have any collateral attached. Unsecured notes are not the same as debentures, which are also unsecured corporate debt (but debentures usually have insurance policies that pay out when the borrower defaults).
 

How it works (Example):

Unsecured notes are typically medium-term debt (usually three to 10 years), but not always. Like all debt, the terms vary, including the interest rates, face values, maturities and other provisions.

Let’s say Company XYZ plans to purchase another company for $20 million. It only has $2 million in cash, so it issues $18 million in unsecured notes. The unsecured notes have a coupon of, say 5%, which is very attractive to investors. However, because there is no collateral associated with the notes, there is a chance that if the acquisition doesn't work out and Company XYZ stops making payments, they may have little compensation if the company is liquidated.

If that note doesn't have any collateral attached, the lender has nothing to seize when the borrower stops making the loan payments. Sure, the lender can sue and recover his or her money that way, but that is a lot more expensive and time consuming.

Why it Matters:

An unsecured note is backed by little more than a promise to pay. Unsecured notes are riskier than secured notes (and even debentures) because the creditor does not have the ability to seize an asset right away if a borrower fails to repay the debt (and there isn't even an insurance policy backing the note). Creditors may of course sue to obtain access to accounts or other assets if the borrower has not paid, but that is more expensive than requiring collateral up front.

Regardless, this lack of security increases the creditor’s risk, which in turn increases the interest rates on unsecured notes.