Final answer:
In bankruptcy, secured bondholders are paid before unsecured creditors, as their bonds are backed by specific assets of the company. If the company cannot pay, these assets can be sold to satisfy the debt. Investors often diversify their bond investments to manage risk.
Step-by-step explanation:
When a firm goes into bankruptcy, the hierarchy of debt repayment becomes crucial. Bondholders who own secured bonds have their claims on the firm's assets prioritized before those holding unsecured debt. This is because a secured bond is backed by specific assets of the company, such as property or equipment. In contrast, unsecured debt, like credit card debt or unsecured bank loans, do not have any such collateral associated with them.
In practice, when a corporate bond issuer is unable to fulfill its payment obligations, it may be declared bankrupt. The company's assets are then liquidated to repay creditors, with secured bondholders being at the front of the line for repayment. They have a lien on the collateral, which means they can seize it in the absence of payment. Following them, unsecured creditors and bondholders receive any remaining assets, but the amount they receive may be much less, and in some cases, they may receive nothing at all.
To mitigate risks, investors may diversify their bond portfolio. This means they could invest in bonds from a variety of companies, so that the failure of a few does not significantly impact their overall investment. While higher-risk bonds, such as junk bonds, offer higher returns, they also come with a greater risk of the issuer defaulting. Diversification is a common strategy to manage, but not eliminate, investment risk.