What Are Debt Securities?
Debt securities are debt instruments that can be bought or sold between two parties. Basic terms are defined, such as the amount borrowed, interest rate, maturity date, and renewal date. Debt securities are issued by corporations, governments, governmental agencies, or other organizations. Each one is essentially a sophisticated form of IOU. Organizations issue debt securities to raise capital, promising interest income in exchange for the use of this money. Most debt securities pay interest at a fixed rate until the maturity date when the principal is returned. For that reason, they are sometimes called fixed-income securities.
In effect, debt securities are financial assets that entitle their owners to a stream of interest payments. Unlike equity obligations, debt obligations require the borrower to repay the principal borrowed. The interest rate for debt security will depend on the perceived creditworthiness of the borrower.
How Debt Securities Work
A debt security is a type of financial asset that is created when one party lends money to another.
Debt financing is one of two primary means of financing for corporations, the other being equity financing. For governments, debt financing through Treasury or municipal bonds is used to generate additional revenue to complement tax revenue.
Corporate debt is issued by corporations seeking to supplement the equity financing provided by shareholders. 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.
Return on invested capital can be unpredictable within a corporation. However, interest payments on debt are typically fixed. Therefore, using debt financing has the potential to greatly magnify financial gain or loss with respect to interest payments. This concept is known as financial leverage. The risk of excess financial leverage is that a company will default on its loans. Corporations are generally seen as more likely than governments to default on loans. Therefore, corporate debt is typically riskier than government debt. As a result, it carries a greater rate of return.
Government bonds are debt securities issued by governments and sold to investors. Investors lend money to the government in return for interest payments called coupon payments. Also, their principal is returned upon the bond’s maturity. Governments, like many large companies, sell bonds to investors in order to finance their operations. In general, government bonds are seen as safer than corporate bonds. However, there are significant variations in the level of risk involved within both categories. For example, U.S. Treasury bonds long have been seen as the closest real-world example of a risk-free bond. But, bonds issued by Greece have been seen in an increasingly negative light following that country’s debt crisis.
Debt securities are also known as fixed-income securities. This is because they generate a fixed stream of income from their interest payments. Debt instruments guarantee that the investor will receive repayment of their initial principal, plus a predetermined stream of interest payments. This is unlike equity investments. With equity, the return earned by the investor is dependent on the market performance of the equity issuer. Debt securities are not without risk. Corporations and even governments that issue debt securities could declare bankruptcy or default on their agreements.
Features of Debt Securities
- Issue date and issue price – Debt securities will always come with an issue date and an issue price at which investors buy the securities when first issued.
- Coupon rate – Issuers are also required to pay an interest rate, also referred to as the coupon rate. The coupon rate may be fixed throughout the life of the security or vary with inflation and economic situations.
- Maturity date – Maturity date refers to the date on which the issuer must repay the principal at face value and remaining interest. The maturity date determines the term that categorizes debt securities. Short-term securities mature in less than a year, medium-term securities mature in 1-3 years, and long-term securities mature in three years or more. The term’s length will impact the price and interest rate given to the investor, as investors demand higher returns for lengthier investments.
- Yield-to-Maturity (YTM) – Yield-to-maturity (YTM) measures the annual rate of return an investor is expected to earn if the debt is held to maturity. It is used to compare securities with similar maturity dates and considers the bond’s coupon payments, purchasing price, and face value.
Risk of Debt Securities
When investors purchase stocks, they are buying a percentage of ownership in a corporation. But, there is no guarantee the stock will go up. It is even possible the company will go bankrupt with the stock price going to zero. Debt securities are generally considered to be a less risky form of investment compared to equity investments such as stocks. One reason is that the borrower is legally required to make the agreed payments of principal and interest. Of course, as is always the case in investing, the actual risk of each security depends 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 (MCO), 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 29, 2020, the Bloomberg Barclays Indices of U.S. corporate bond yields showed that double-A-rated corporate bonds had an average annual yield of 1.34%, compared to 2.31% for their triple-B-rated counterparts. Since the double-A 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
Equity securities represent a claim on the earnings and assets of a corporation. 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. In return, they have the right to be repaid the principal and interest on the bond. In contrast, when someone buys stock from a corporation, they essentially buy a percentage of ownership in the company. If the company profits, the investor profits as well. But, if the company loses money, the stock also loses money.
- Debt securities are fundamentally different from equities in their structure, the return of capital, and legal considerations. Debt securities include a fixed term for principal repayment with an agreed schedule for interest payments. As a result, a fixed rate of return and the yield-to-maturity can be calculated to predict an investor’s earnings. Investors can choose to sell debt securities prior to maturity, where they may realize a capital gain or loss. Debt securities are generally regarded as holding less risk than equities.
- Equity does not come with a fixed term, and there is no guarantee of dividend payments. Rather, dividends are paid at the company’s discretion and will vary depending on how the business is performing. Because there are no scheduled dividend payments or stock price guarantees, equities do not offer a specified rate of return. Investors will receive the market value of shares when sold to third parties. At that time they may realize a capital gain or loss on their initial investment.
Example of a Debt Security
Emma recently purchased a home using a mortgage from her bank. From Emma’s perspective, the mortgage represents a liability. She must service it by making regular interest and principal payments. From the perspective of her bank, however, Emma’s mortgage loan is an asset. It is a debt security that entitles them to a stream of interest and principal payments. As with other debt securities, Emma’s mortgage agreement with her bank sets out the key terms of the loan. This includes the face value, interest rate, payment schedule, and maturity date. In Emma’s case, the agreement also includes the specific collateral of the loan, namely the home which she purchased. As the holder of this debt security, Emma’s bank has the option of either continuing to hold the asset or selling it on the secondary market to a company that might then package the asset into a collateralized mortgage obligation (CMO).
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