A debt security is a debt instrument that can be bought or sold between two parties and has terms such as the notional amount (the amount borrowed), interest rate, and maturity and renewal date.
What Are Examples of Debt Securities?
Examples of debt securities include government bonds, corporate bonds, certificates of deposit (CDs), municipal bonds, or preferred stock. They can also be collateralized securities like collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs), mortgage-backed securities (MBSs), and zero-coupon bonds.
Key Takeaways
- Debt securities are financial assets entitling 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 depends on the perceived creditworthiness of the borrower.
- Common types include government bonds, corporate bonds, municipal bonds, collateralized bonds, and zero-coupon bonds.
How Debt Securities Work
A debt security is a financial asset 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 preset number of interest payments and the return of their principal upon the bond’s maturity.
Government bonds are debt securities issued by governments and backed by faith in that government. Investors lend money to the government in return for interest payments (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 interest payments. Unlike equity investments, in which the return is dependent on the market performance, debt instruments guarantee repayment of the principal plus predetermined interest payments. That said, they aren’t free from risk as issuers could declare bankruptcy or default on agreements.
Risks of Debt Securities
Because borrowers are legally required to make payments, debt securities are generally considered less risky compared to equity investments like stocks. However, the actual risk depends on specific characteristics.
For instance, a company with a strong balance sheet might be less likely to default than a startup in an emerging market. Such differences are reflected in credit ratings by agencies like Standard & Poor’s, Moody’s, and Fitch Ratings. Hence, there’s a tradeoff between risk and return; companies with higher ratings usually offer lower interest rates.
For example, Moody’s Seasoned Aaa corporate bond yield might be 4.66%, while its Seasoned Baa corporate bond yield could be 5.74%. Lower perceived risk means lower yield for less risky securities.
Debt Securities vs. Equity Securities
Equity securities represent a claim on the earnings and assets of a corporation, whereas debt securities are investments in debt instruments. Buying a corporate bond involves loaning the corporation money with repayment terms. If a corporation goes bankrupt, bondholders are paid before shareholders.
In contrast, buying stock means purchasing a piece of the company. Profits translate to investor profit, but losses can result in devalued stock.
What Is an Example of a Debt Security?
Bonds, whether government or corporate, are the most common example. Investors purchase these and receive a stream of income via interest. At bond maturity, the issuer buys it back from the investor.
Who Issues Debt Securities?
Corporations and governments commonly issue debt securities. These raise money for projects, growth, or operations. Corporations also issue them to pay down other debts.
What Is the Risk of a Debt Security?
If the issuer defaults, there is a risk to debt security holdings. Issuers undergoing financial hardship may fail to make interest payments or repurchase outstanding debt, particularly if they face bankruptcy.
The Bottom Line
Debt securities are debt instruments that investors purchase seeking returns. Issued by corporations, governments, and other entities, they are a significant tool for financing various needs. Unlike equity securities such as stocks, they are generally perceived as safer investments. Debt securities like bonds can be effective for investors looking to diversify their portfolios.
Related Terms: Debt Instrument, Collateralized Debt Obligations, Zero-Coupon Bonds, Fixed-Income Securities.
References
- U.S. Securities and Exchange Commission. “Mortgage-Backed Securities and Collateralized Mortgage Obligation”.
- U.S. Securities and Exchange Commission. “What Are Corporate Bonds?”
- U.S. Securities and Exchange Commission. “Bonds”.
- FINRA. “Investment Products: Bonds”.
- U.S. Securities and Exchange Commission. “Risk and Return”.
- St. Louis Fed, FRED. “Moody’s Seasoned Baa Corporate Bond Yield”.
- St. Louis Fed, FRED. “Moody’s Seasoned Aaa Corporate Bond Yield”.
