Unsecured Note: What it is, How it Works

What Is an Unsecured Note?

An unsecured note is a loan that is not secured by the issuer's assets. Unsecured notes are similar to debentures but offer a higher rate of return. Unsecured notes provide less security than a debenture. Such notes are also often uninsured and subordinated. The note is structured for a fixed period.

Understanding Unsecured Note

Companies sell unsecured notes through private offerings to generate money for corporate initiatives such as share repurchases and acquisitions. An unsecured note is not backed by any collateral and thus presents more risk to lenders. Due to the higher risk involved, these notes' interest rates are higher than with secured notes.

In contrast, a secured note is a loan backed by the borrower's assets, such as a mortgage or auto loan. If the borrower defaults, these assets will go towards the repayment of the note. For this reason, collateral assets must be worth at least as much as the note. Additional examples of collateral that can be pledged include stocks, bonds, jewelry, and artwork.

Unsecured Note and Credit Rating

Credit rating agencies will often rate debt issuers. For example, in the case of Fitch, this agency will offer a letter-based credit rating that reflects the chances that the issuer will default, based on internal (i.e., the stability of cash flows) and external (market-based) factors.

Investment Grade

• AAA: Companies of exceptionally high quality (reliable, with consistent cash flows)
• AA: Still high quality; slightly more risk than AAA
• A: Low default risk; somewhat more vulnerable to business or economic factors
• BBB: Low expectation of default; business or economic factors could adversely affect the company

Non-Investment Grade

• BB: Elevated vulnerability to default risk, more susceptible to adverse shifts in business or economic conditions; still financially flexibility
• B: Degrading financial situation; highly speculative
• CCC: Real possibility of default
• CC: Default is probably
• C: Default or default-like process has begun
• RD: Issuer has defaulted on a payment
• D: Defaulted

Special Considerations

Liquidation occurs when a company is insolvent and cannot pay its obligations when they come due. As company operations come to an end, its remaining assets go towards paying creditors and shareholders who purchased stakes and/or made loans as the company expanded. Each of these parties has a priority in the order of claims to company assets.

The most senior claims belong to secured creditors, followed by unsecured creditors, including bondholders, the government (if the company owes taxes), and employees (if the company owes them unpaid wages or other obligations). Finally, shareholders receive any remaining assets, beginning with those holding preferred stock followed by holders of common stock.