What is Encumbrance?
An encumbrance is a limitation on the ownership of a property.
How Do Encumbrances Work?
In the real estate world, an encumbrance is similar to a lien. The bond world also includes encumbrances. For instance, let's consider a $100 million bond issue by Company XYZ. Let's say that Company XYZ is willing to pledge $100 million of its assets to the bondholders (that is, let the bondholders place liens on specific assets that they may seize in the event of default), giving them a little extra assurance that they will be paid on time. In that case, the bonds would be considered securitized or asset-backed because the assets have $100 million of encumbrances on them.
Why Do Encumbrances Matter?
Encumbrances provide security to lenders and bond investors in the case of bankruptcy or default. For example, it is important to note that debentures (bonds backed by the full faith and credit of the issuer) do not have encumbrances. That is, they are not secured by specific pieces of property or collateral and they do have a general claim on the assets and earnings of the issuer. Therefore, if the issuer were to liquidate, the holders of the debenture bonds have a claim on any assets not specifically pledged to secure other debt.
Companies that are extremely creditworthy often have no reason to encumber specific assets in order to sell a bond issue because they'll still pay relatively low interest rates. (This is why debentures can sometimes sell for more than bonds with encumbrances from less creditworthy issuers.) Sometimes issuers also want to leave their assets unencumbered in order to make future financings possible.