What are debt securities?
What are the features of debt security?
What types of debt security investments are available in the market?
In this article, we will break down the notion of “debt securities” so you know all there is to know about it.
We will look at debt securities definition, different types of debt securities, what are the characteristics and features of debt instruments, the investment risk associated with them, compare debt securities vs equity securities, we’ll look at their accounting treatment, examples and more.
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What are debt securities
Debt securities are negotiable financial instruments (or debt instruments) where one party (investor) lends money to the other (issuer).
Said differently, debt securities represent a claim to borrowed funds that must be paid back in accordance with the terms of the debt security agreement.
Companies, businesses and governments need money to operate.
In some cases, they will choose to finance their operations by borrowing the money.
By issuing bonds or debentures, issuers reach out to investors asking them to lend some money so they can finance their business operations and, in exchange, they promise to repay the face value of the sums borrowed along with a set rate of interest.
For example, typical debt investment examples are:
- Certificate of deposit (CD)
- Commercial paper
- Government bond
- Corporate bond
- Municipal bond
- Collateralized debt obligations (CDO)
- Collateralized mortgage obligations (CMO)
- Mortgage-backed securities
- Zero-coupon securities
A debt security represents a financial asset to the lender (or investor) and a debt obligation to the borrower (issuer).
Debt securities are attractive investment options as the lender is guaranteed that the borrower will reimburse the principal along with a pre-established interest representing the profit to the investor.
Bonds (either government bonds or corporate bonds) represent a contractual agreement between the corporation or government where the lender agrees to lend a certain amount of money and the borrower promises to pay back the principal along with an agreed-upon rate of interest on the maturity date of the loan.
Investors looking to have a defined return on investment, a steady and regular stream of income from interest payments and take less overall risk will prefer to invest in debt security investments than equity investments.
When the issuer sells the debt instrument for the first time to the investors, they are essentially selling the instrument to a primary market.
Once debt securities are issued, they can be bought and sold by investors on the open market.
When the debt instrument is exchanged between buyers and sellers in debt exchanges or debt markets, that exchange happens on the secondary market.
Debt securities definition
To understand the term “debt securities”, we must first understand what “securities” or “security” means.
The term security represents a financial instrument having some monetary value.
Securities are negotiable and fungible.
In general, securities can be in the form of “equity securities” or “debt securities”.
In this article, we will focus on the securities by way of debt.
Now, “debt securities” represents a tradable loan or financial instrument where the lender is entitled to receive payment of the principal and interest over a certain period of time and the borrower is obligated to make such payments.
According to Investopedia, debt securities are defined as:
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.
According to the Corporate Finance Institute, the debt security financial definition can be framed as follows:
A debt security is any debt that can be bought or sold between parties in the market prior to maturity.
The debt security definition can be summed up as a tradable instrument that can be bought and sold on the debt market having the characteristics of a loan.
The lender can transfer the legal ownership of the debt security to another investor.
Types of debt securities
There are different types of debt securities that you can purchase as an alternative investment to equity investments:
- Corporate bonds
- Government bonds
- Treasury bills (T-Bills)
- Treasury notes (T-Notes)
- Treasury bonds (T-Bonds)
- Savings bonds
- Fixed-income securities
- Money market instruments
- Commercial paper
- Exchange-Traded Notes (ETN)
- Floating rate notes
- Variable-income securities
- Variable-rate demand obligations
- Euro debt securities
- Sub-sovereign government bonds
- Municipal bonds
- Supranational bonds
- Secured debt security
- Senior debt security
- Subordinated debt security
- Unsecured debt security
- Short-term debt security
- Long-term debt security
- Packaged debt securities
Features of debt securities
Typically, debt securities will have the following features:
- The lender (who is the creditor of the debt)
- The borrower (who is the debtor of the debt)
- The notional amount or issue price (sums of money borrowed)
- The issue date (the date the loan is granted)
- The interest rate or coupon rate (creditor’s profit on capital)
- The interest payments or coupon payments (payments to be made on a regular interval)
- The maturity date (data where all capital and interest are finally due)
- The renewal date (if the loan term extends beyond the initial maturity date)
- The yield-to-maturity or YTM (investor’s expected rate of return)
In most cases, corporate bonds and government bonds oblige the borrower to pay fixed interest payments (or coupon payments) to the lender during the term of the loans.
We call this “fixed-income investments” or “fixed-income debt securities”.
However, not all debt securities offer such payment features.
Some debt instruments are designed to incorporate the interest payments in the sale price while others offer variable interest or demand obligations.
Debt securities risk
Debt securities carry two types of risk:
- Credit risk
- Price risk
An issuer’s credit history and overall financial position will translate into a certain degree of risk for the lender.
Although the lender’s capital and interest repayment is guaranteed, the corporation or corporate borrower may file for bankruptcy or become insolvent to a point that it defaults on the debt security payments.
On the other hand, government debt securities are safer than corporate debt security as the government will probably not go bankrupt and may not run the risk of defaulting on its payments.
The price risk is the possible volatility in the fair market value of the debt instrument on the market based on the market rate of interest.
Changes in interest rates will have a direct impact on the market value of the debt financial instrument.
In consideration of the higher level of risk assumed by investors, when lending money to corporations via corporate bonds, debentures or notes, will receive a higher rate of interest than if it were to lend the same amount of money to the U.S. government.
In other words, a higher interest return compensates a lender for a higher level of risk assumed by lending money to a particular issuer.
In general and from an investment point of view, debt will be less risky than equity investments such as buying company stocks.
To gauge the level of risk, investors rely on the credit ratings offered by prominent rating agencies.
There are three major credit rating agencies that rate the credit of companies and governments so investors can have a better sense of their investment risk, they are:
- Standard & Poor’s (S&P)
- Moody’s Corporation (MCO)
- Fitch Ratings
Debt securities vs equity securities
Debt securities represent a financial asset where the investor (creditor or lender) is entitled to have his or her investment capital paid back along with interest over a certain period of time by the issuer (borrower).
Whereas equity securities represent shares or stocks that an investor purchases in a company entitling the investor a claim on future earnings of the company as a company owner and the residual asset of the business once all creditors and liabilities are cleared.
A debt security holder is guaranteed the reimbursement of the initial investment along with a pre-defined interest whereas an equity security holder becomes a part-owner of the business and bets that the company will be more profitable in the future allowing it to pay dividends and appreciate in stock value.
In the event of bankruptcy, debt securities must be paid off before any residual value of the business is distributed to the equity investors.
In other words, security in debt will have preference over security in equity.
For example, bondholders will be paid back their principal and interest before shareholders can get any residual sums of money once all creditors and liabilities have been paid off.
Debt securities accounting
Debt securities are a financial investment in instruments like bonds, debentures or notes.
When debt securities are purchased, the investor will need to record the acquisition cost of the debt security as a “debt investment” in its books.
The acquisition costs will typically represent the price paid to purchase the debt security along with the transaction costs like investment fees or broker fees.
As you can see, debt securities are recorded as an “asset” by the borrower (investor).
Conversely, the issuer will need to record the issuance of debt securities to the market as a “liability” on its balance sheet.
The issuer is liable to pay principal and interest in the future.
This liability must be reflected in its financial statements.
Debt securities examples
There are different examples of debt securities that we can provide you to better illustrate how they work.
Let’s look at a corporate bond and mortgage example.
Example 1: Corporate bonds
Company ABC is a mature and stable company with a good credit score who needs $10,000,000 in financing to open a new manufacturing plant.
To this effect, it decides to issue $10,000,000 in corporate bonds promising investors a 5% guaranteed rate of interest and a 5-year maturity.
John buys $10,000 worth of the Company ABC corporate bonds.
John expects that Company ABC reimburses the full amount of the loaned principal ($10,000) along with interest ($500) in 5 years after the bond issue date.
Company ABC (the issuer) is happy as it is able to raise $10,000,000 from investors and John (the investor) is happy as he has a guaranteed return of $500 (or 5%) on his principal investment.
For Company ABC, the bonds represent a financial debt whereas for John it represents a financial asset.
Example 2: Mortgage
Mary needs $300,000 to purchase a house.
She approaches her bank who agrees to lend her $300,000 payable in monthly installments and where the full mortgage must be paid off in 25 years after it is granted.
The mortgage agreement, just like any other debt instrument, will have the following features:
- Issue date
- Principal amount
- Defined interest
- Fixed payments
- Maturity date
The mortgage agreement can be considered to be “secured debt” as the bank secures Mary’s repayment obligation by taking the home as collateral.
Although Mary acquires the title to the property, the bank will register a lien against the property so that if Mary is unable to pay back the mortgage or defaults on payment, the bank can foreclose Mary.
Some banks may take a collection of mortgage agreements they have on their books and sell them on the open market as collateralized mortgage obligations.
Debt securities FAQ
What is a debt security
A debt security is a debt instrument or financial asset that is issued by governments, government agencies or corporations where the borrower (issuer) borrows some money from the investor (lender) and promises to pay back the capital and a set amount of interest by pre-defined maturity date.
A debt security can be seen as a form of IOU.
When the borrower has to make interest payments on a regular basis to the investor, we refer to such debt security as fixed income securities.
What is the difference between debt and equity securities
There are some fundamental differences between debt and equity securities.
Characteristics of debt securities
Characteristics of equity securities
Should you invest in debt securities
Debt security investments are a good alternative option to other forms of investment if the following factors are important for you:
- You want to have your initial investment returned to you
- You want to have your profits defined in advance
- You are looking for a steady stream of income
- You are looking to take less risk than other types of investment
Is a loan a debt security
A debt security, by definition, is a financial instrument that can be traded, bought, sold, negotiated or transacted upon.
A loan is a type of debt where a lender lends money to the borrower for a certain period of time.
A corporate bond is a debt security as it can be traded and there is a market where it can be bought and sold.
A loan does not have a market, it cannot readily be traded.
As such, a plain vanilla loan is not considered a debt security.
What is the difference between debt securities vs bonds
Debt securities refer to any type of financial asset that has the characteristics of a loan.
Debt securities can be bonds, debentures, notes, commercial paper, savings bonds, packaged debt securities or others.
On the other hand, bonds represent a specific type of debt security.
Bonds can be issued by governments or corporations.
Just like a loan, the bond investor will receive the face value of the bond on the bond’s maturity date along with a pre-established rate of interest.
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