Rixon Capital

Impact Of Debt Ranking & Underlying Security Type On Risk

Debt securities are financial instruments that represent a loan made by an investor to a borrower. These securities come in various levels of risk and are often backed by collateral, which serves as a form of security for the lender. Understanding the different levels of debt security and the types of collateral involved is crucial for investors as it directly impacts the risk associated with their investments.

Levels of Debt Security

Debt securities can be categorised into several levels of security based on their priority in case of the issuer’s default. The main levels of debt security include:

  1. Secured Debt: Secured debt, also known as “senior secured debt” is backed by specific assets or collateral. In the event of a default, the lender has a claim on the collateral to recover the outstanding debt. Examples of secured debt include mortgage-backed securities (MBS), asset-backed securities (ABS), and secured private credit strategies.
  2. Unsecured Debt: Unsecured debt does not have specific collateral backing it. Instead, it relies on the issuer’s overall creditworthiness and ability to repay. If the issuer defaults, unsecured debt holders are considered general creditors and may have a lower chance of recovering their investment compared to secured debt holders.
  3. Subordinated Debt: Subordinated debt is junior to other forms of debt in the capital structure. In the event of default, subordinated debt holders are paid after secured and unsecured debt holders. This makes subordinated debt riskier, but it often offers higher yields to compensate for the added risk.

Types of Collateral and Their Impact on Risk:

Collateral plays a significant role in debt security by providing a form of protection to the lender. The type of collateral used can vary widely, and it has a direct impact on the risk associated with the investment. Here are some common types of collateral and their risk implications:

  1. Real Estate Collateral: Collateralised by real estate properties, such as homes or commercial buildings. Mortgage-backed securities (MBS) are a common example. The risk depends on the real estate market’s stability, as well as factors like location, property value, and the quality of the mortgages.
  2. Asset-Backed Collateral: Collateralised by a pool of assets, which can include equipment and receivables. Asset-backed securities (ABS) are typical examples. The risk is influenced by the performance of the underlying assets and the creditworthiness of borrowers.
  3. Corporate Assets Collateral: Some corporate bonds are secured by specific corporate assets, such as inventory or equipment. The risk is tied to the value and liquidity of these assets.
  4. Cash Collateral: Certain loans or bonds may be secured by cash held in reserve. This type of collateral carries lower risk because it provides a readily available source of repayment.
  5. Equipment Collateral: Collateralised by machinery, vehicles, or equipment. The risk is tied to the value and condition of the equipment and the market demand for such assets.
  6. Government Collateral: Some bonds issued by governments are backed by the government’s taxing power or its ability to print money. These are typically considered low-risk investments.

Impact on Risk:

The presence and quality of collateral can significantly impact the risk associated with a debt security:

  • Higher Collateral Quality: High-quality collateral, such as prime real estate or government backing, reduces the risk of default and can result in lower interest rates for investors.
  • Lower Collateral Quality: Lower-quality collateral, or collateral that is subject to market fluctuations, increases the risk of default and may lead to higher interest rates or yields for investors.
  • No Collateral: Unsecured debt or debt with no specific collateral relies solely on the issuer’s creditworthiness. This is often riskier than secured debt.

Investors should carefully assess the level of debt security and the type of collateral when making investment decisions. Diversifying across different levels of security and types of collateral can help manage risk in a portfolio and achieve a balance between risk and potential return. Furthermore, staying informed about economic conditions, market trends, and issuer credit ratings is essential for making informed investment choices in the debt securities market. Rixon Capital’s approach emphasises these factors, offering clients the tools and insights necessary to navigate the complexities of private credit investing with confidence.