What Is a Debt Security?
A debt security is a debt instrument that can be bought or sold between two parties and has basic terms defined, such as the notional amount (the amount borrowed), interest rate, and maturity and renewal date.
Examples of debt securities include a government bond, corporate bond, certificate of deposit (CD), municipal bond, or preferred stock. Debt securities can also come in the form of collateralized securities, such as collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs), mortgage-backed securities (MBSs) issued by the Government National Mortgage Association (GNMA), and zero-coupon securities.
Key Takeaways
- Debt securities are financial assets that entitle their owners to a stream of interest payments.
- Unlike equity securities, debt securities require the borrower to repay the principal borrowed.
- The interest rate for a debt security will depend on the perceived creditworthiness of the borrower.
- Bonds, such as government bonds, corporate bonds, municipal bonds, collateralized bonds, and zero-coupon bonds, are common types of debt securities.
How Debt Securities Work
A debt security is a type of financial asset that is created when one party lends money to another. For example, corporate bonds are debt securities issued by corporations and sold to investors. Investors lend money to corporations in return for a pre-established number of interest payments, along with the return of their principal upon the bond's maturity date.
Government bonds, on the other hand, are debt securities issued by governments and backed by faith in that government, which are sold to investors. Investors lend money to the government in return for interest payments (called coupon payments) and a return of their principal upon the bond's maturity.
Debt securities are also known as fixed-income securities because they generate a fixed stream of income from their interest payments.Unlike equity investments, in which the return earned by the investor is dependent on the market performance of the equity issuer, debt instruments guarantee that the investor will receive repayment of their initial principal, plus a predetermined stream of interest payments.
Of course, this contractual guarantee does not mean that debt securities are without risk, since the issuer of the debt security could declare bankruptcy or default on their agreements.
Risks of Debt Securities
Because the borrower is legally required to make these payments, debt securities are generally considered to be a less risky form of investment compared to equity investments such as stocks. Of course, as is always the case in investing, the true risk of a particular security will depend on its specific characteristics.
For instance, a company with a strong balance sheet operating in a mature marketplace may be less likely to default on its debts than a startup company operating in an emerging marketplace. In this case, the mature company would likely be given a more favorable credit rating by the three major credit rating agencies: Standard & Poor’s (S&P), Moody’s Corporation, and Fitch Ratings.
In keeping with the general tradeoff between risk and return, companies with higher credit ratings will usually offer lower interest rates on their debt securities and vice versa. For example, as of July 2023, Moody's Seasoned Aaa corporate bond yield is 4.66% whereas its Seasoned Baa corporate bond yield is 5.74%.
Since the Aaa rating denotes a lower perceived risk of credit default, it makes sense that market participants are willing to accept a lower yield in exchange for these less risky securities.
Debt Securities vs. Equity Securities
Equity securities represent a claim on the earnings and assets of a corporation, while debt securities are investments in debt instruments. For example, a stock is an equity security, while a bond is a debt security. When an investor buys a corporate bond, they are essentially loaning the corporation money and have the right to be repaid the principal and interest on the bond.
In the event a corporation goes bankrupt, it pays bondholders before shareholders.
In contrast, when someone buys stock from a corporation, they essentially buy a piece of the company. If the company profits, the investor profits as well, but if the company loses money, the stock also loses money.
What Is an Example of a Debt Security?
The most common example of a debt security is a bond, whether that be a government bond or corporate bond. These securities are purchased by an investor and pay out a stream of income in the form of interest payments. At the bond's maturity, the issuer buys back the bond from the investor.
Who Issues Debt Securities?
The most common issuer of debt securities are corporations and governments. Both issue debt securities to raise money: governments to finance projects or for day-to-day operations and corporations to fund growth, pay down other debt, and also to finance day-to-day operations.
What Is the Risk of a Debt Security?
The risk of a debt security is that the issuer defaults on their debt. If the issuer experiences financial hardship, they may no longer be able to make interest payments on their outstanding debt. They may also not be able to repurchase their outstanding debt at maturity, particularly if they go bankrupt.
The Bottom Line
Debt securities are debt instruments that investors purchase seeking returns. They are issued by corporations, governments, and other entities in order to raise money to finance various needs. They are an alternative option to equity securities, such as stocks, and are generally considered safer investments. Debt securities, such as bonds, can be a good way for investors to diversify their portfolios.
FAQs
Debt securities are debt instruments that investors purchase seeking returns. They are issued by corporations, governments, and other entities in order to raise money to finance various needs. They are an alternative option to equity securities, such as stocks, and are generally considered safer investments.
What are the different types of debt securities? ›
Bonds (government, corporate, or municipal) are one of the most common types of debt securities, but there are many different examples of debt securities, including preferred stock, collateralized debt obligations, euro commercial paper, and mortgage-backed securities.
What is a debt security investment? ›
Debt securities are negotiable financial instruments, meaning they can be bought or sold between parties in the market. They come with a defined issue date, maturity date, coupon rate, and face value. Debt securities provide regular payments of interest and guaranteed repayment of principal.
What are the 3 classifications of debt investments? ›
Debt securities should be classified into one of three categories at acquisition:
- Held to maturity.
- Available for sale.
- Trading.
There are four main types of security: debt securities, equity securities, derivative securities, and hybrid securities, which are a combination of debt and equity.
How to buy debt securities? ›
Buying through a bank, broker, or dealer
Individuals, organizations, fiduciaries, and corporate investors may buy Treasury securities through a bank, broker, or dealer. With a bank, broker, or dealer, you may bid for Treasury marketable securities non-competitively or competitively, but not both, for the same auction.
What are debt securities for dummies? ›
Debt securities are debt instruments that investors purchase seeking returns. They are issued by corporations, governments, and other entities in order to raise money to finance various needs.
What is the most common type of debt security? ›
The most common type of debt securities are fixed-income securities, like bonds.
What is debt security in simple terms? ›
The term “debt securities” has a number of meanings, but generally, it refers to financial instruments that contain a promise from the issuer to pay the holder a defined amount by a specific date, i.e., the point at which the debt security matures.
Why do companies invest in debt securities? ›
Reasons why companies might elect to use debt rather than equity financing include: A loan does not provide an ownership stake and, so, does not cause dilution to the owners' equity position in the business. Debt can be a less expensive source of growth capital if the Company is growing at a high rate.
A debt security is an investment asset that involves a debt rather than ownership in a company. A common example is when a corporation or government agency issues a bond and sells it to investors.
What are the 4 main investment types? ›
Bonds, stocks, mutual funds and exchange-traded funds, or ETFs, are four basic types of investment options.
How do you value debt securities? ›
The DCF method is a widely used valuation technique for debt securities. It involves projecting the future cash flows of a debt instrument, discounting these cash flows to their present value using an appropriate discount rate, and summing the present values to arrive at the instrument's valuation.
Which item cannot be used to secure a debt? ›
credit card cannot be used to secure a debt because it is not an asset, but rather a line of credit. Tangible assets like houses, cars, or collections can be used as collateral due to their quantifiable value. Explanation: The item that cannot be used to secure a debt among those listed is a credit card.
What is the best asset to own? ›
You might also want to know which is better for you, CD vs Roth IRA.
- Asset #2: Bonds.
- Asset #3: Real estate investment trusts (REITs)
- Asset #4: Dividend-yielding stocks.
- Asset #5: Property rentals.
- Asset #6: Peer-to-peer lending.
- Asset #7: Creating your own product (how to build an asset)
Safe assets such as U.S. Treasury securities, high-yield savings accounts, money market funds, and certain types of bonds and annuities offer a lower risk investment option for those prioritizing capital preservation and steady, albeit generally lower, returns.
Are bonds debt securities? ›
What are bonds? A bond is a debt security, like an IOU. Borrowers issue bonds to raise money from investors willing to lend them money for a certain amount of time. When you buy a bond, you are lending to the issuer, which may be a government, municipality, or corporation.
How much is a $100 savings bond worth after 30 years? ›
How to get the most value from your savings bonds
| Face Value | Purchase Amount | 30-Year Value (Purchased May 1990) |
|---|
| $50 Bond | $100 | $207.36 |
| $100 Bond | $200 | $414.72 |
| $500 Bond | $400 | $1,036.80 |
| $1,000 Bond | $800 | $2,073.60 |
Corporate debt issues are commonly issued through the underwriting process in which one or more securities firms or banks purchase the issue in its entirety from the issuer and form a syndicate tasked with marketing and reselling the issue to interested investors.
Are T-bills a good investment? ›
While interest rates and inflation can affect Treasury bill rates, they're generally considered a lower-risk (but lower-reward) investment than other debt securities. Treasury bills are backed by the full faith and credit of the U.S. government. If held to maturity, T-bills are considered virtually risk-free.
They are financial instruments that have the promise of payment by the issuer to the holder at an agreed amount of money at a particular time, which is usually the point of maturity of the financial instrument. They can also be described as financial assets used to raise an entity's debt upon being invested.
What are debt securities classified as? ›
A debt security is any security that is representing a creditor relationship with an outside entity. The three classifications under U.S. GAAP are trading, available-for-sale, and held-to-maturity.
What are the types of securitized debt? ›
Common Securitized Debt Instruments
- Mortgage-backed Securities (MBS) Mortgage-backed securities (MBS) are bonds that are secured by homes or real estate loans. ...
- Asset-backed Securities (ABS) Asset-backed securities (ABS) are bonds that are created from consumer debt.
Types of securities
- Equity securities. Equity securities, commonly known as stocks or shares, represent ownership in a company. ...
- Debt securities. ...
- Hybrid securities. ...
- Derivative securities. ...
- Asset-backed securities.
