What is a Debt Security?
A debt security is any debt that can be bought or sold between parties in the market prior to maturity. Its structure represents a debt owed by an issuer (the government, an organization, or a company) to an investor who acts as a lender.
Understanding Debt Securities
Debt securities are negotiable financial instruments, meaning their legal ownership is readily transferrable from one owner to another. Bonds are the most common form of such securities. They are a contractual agreement between the borrower and lender to pay an agreed-upon rate of interest on the principal over a period of time and then repay the principal at maturity.
Bonds can be issued by the government and non-government entities. They are available in various forms. Typical structures include fixed-rate bonds and zero-coupon bonds. Floating-rate notes, preferred stock, and mortgage-backed securities are also examples of debt securities. Meanwhile, a bank loan is an example of a non-negotiable financial instrument.
- 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. They can be sold prior to maturity to allow investors to realize a capital gain or loss on their initial investment.
Main Features of Debt Securities
1. 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.
2. 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.
3. Maturity date
Maturity date refers to when 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.
4. Yield-to-Maturity (YTM)
Lastly, 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.
Debt Securities vs. Equity Securities
Debt securities are fundamentally different from equities in their structure, return of capital, and legal considerations. Debt securities include a fixed term for principal repayment with an agreed schedule for interest payments. Hence, a fixed rate of return, the yield-to-maturity, can be calculated to predict an investor’s earnings.
Investors can choose to sell debt securities before 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 vary depending on how the business is performing. Because there is no dividend payment schedule, equities do not offer a specified rate of return.
Investors will receive the market value of shares when sold to third parties, where they may realize a capital gain or loss on their initial investment.
Why Invest in Debt Securities?
1. Return on capital
There are many benefits to investing in debt securities. First, investors purchase debt securities to earn a return on their capital. Debt securities, such as bonds, are designed to reward investors with interest and the repayment of capital at maturity.
The repayment of capital depends on the ability of the issuer to meet their promises – failure to do so will lead to consequences for the issuer.
2. Regular stream of income from interest payments
Interest payments associated with debt securities also provide investors with a regular stream of income throughout the year. They are guaranteed, promised payments, which can assist with the investor’s cash flow needs.
3. Means for diversification
Depending on the strategy of the investor, debt securities can also act to diversify their portfolio. In contrast to high-risk equity, investors can use such financial instruments to manage the risk of their portfolios.
They can also stagger the maturity dates of multiple debt securities ranging from short-term to long-term. It allows investors to tailor their portfolios to meet future needs.
Thank you for reading CFI’s guide on Debt Security. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below: