Debt Security
A debt instrument that can be purchased or sold between two parties
What Is a Debt Security?
A debt security is a debt instrument that can be purchased or sold between two parties. It defines basic terms such as the notional amount (the amount borrowed), interest rate, maturity, and renewal date.
Government bonds, corporate bonds, certificates of deposit (CDs), municipal bonds, and preferred stock are all examples of debt securities. Debt securities include CDOs, CMOs, mortgage-backed securities issued by the Government National Mortgage Association (GNMA), and zero-coupon securities.
Debt securities are negotiable financial instruments which means that they can be easily transferred from one owner to another.
Bonds are the most common type of security. It is a contractual agreement between the borrower and the lender to pay an agreed-upon interest rate on the principal over a set period of time and then repay the principal at maturity. Bonds can be issued by both the government and non-governmental organizations.
They come in a variety of types. Fixed-rate bonds and zero-coupon bonds are common bond types.
Debt securities include floating-rate notes, preferred stock, and mortgage-backed securities. On the other hand, a bank loan is an example of a non-negotiable financial instrument.
Impairment is the reduction in the value of an asset caused by a decrease in its quantity, quality, or market value. Although it is a relatively complex accounting concept, it essentially means that any impairment losses must be recorded on a company's profit and loss statement.
You can do this by comparing the asset's recoverable value to its book value before calculating the loss. As a result, debt security impairment refers to a circumstance where the debt security's fair value is less than its amortized cost basis.
Key Takeaways
- Debt securities are financial assets that entitle their owners to future interest payments.
- Debt securities, as opposed to equity securities, require the borrower to repay the principal borrowed.
- The interest rate on a debt security is determined by the borrower's perceived creditworthiness.
- Bonds are a common type of debt security, including government, corporate, municipal, collateralized, and zero-coupon bonds.
Features of a debt security
Some of the main features are:
1. Issue date and issue price
Debt securities will always have an issue date and an issue price, at which investors can purchase the securities when they are first issued.
2. Coupon rate
Issuers must also pay an interest rate, also known as the coupon rate, to the security holder. The coupon rate may be fixed for the duration of the security or may vary in response to inflation and economic conditions.
3. Maturity date
The maturity date is the date on which the issuer must repay the principal and any remaining interest. The term used to classify debt securities is determined by the maturity date.
Short-term investments mature in less than a year, medium-term investments in 1-3 years, and long-term investments in three years or more. The length of the term will affect the price and interest rate offered to the investor, as investors expect higher returns for longer investments.
4. Yield to maturity (YTM)
Yield-to-maturity (YTM) calculates the annual rate of return an investor can expect if the debt is held until maturity. It is used to compare securities with similar maturities and considers the bond's coupon payments, purchase price, and face value.
How Debt Securities Work
A debt security is a financial asset formed when one party lends money to another. Corporate bonds, for example, are debt securities issued by corporations and sold to investors.
Investors lend money to corporations in exchange for a set number of interest payments and the return of their principal when the bond matures.
On the other hand, government bonds are government-issued debt securities sold to investors. Investors lend money to the government in exchange for interest payments (known as coupon payments) and the repayment of principal when the bond matures.
Debt securities are also referred to as fixed-income securities because their interest payments provide a steady and consistent income stream.
Unlike equity investments, where the investor's return depends on the equity issuer's market performance, debt instruments ensure that the investor will be repaid their initial principal along with a predetermined source of interest payments regardless of the issuer’s market performance.
Of course, this does not mean that debt securities are risk-free because the debt security's issuer may declare bankruptcy.
Examples of debt securities
Four examples to understand more about debt securities:
1. Zero-coupon bonds
These bonds have no interest component and are issued at a discount to compensate for the lack of fixed interest payments.
Some bonds are issued as zero-coupon instruments, while others become zero-coupon instruments after being deprived of their coupons and are repackaged as zero-coupon bonds by a financial institution.
Because they provide the entire payment at maturity, zero-coupon bonds tend to fluctuate in price much more than coupon bonds.
A bond is a means for corporations or the government to raise capital. When bonds are issued, investors buy them, effectively becoming lenders to the issuing entity.
Throughout the bond's life, investors earn a return through recurring coupon payments made semiannually or annually.
When the bond matures, the bondholder receives the face value. A corporate bond's par or face value is typically stated as $1,000. When a corporate bond is issued at a discount, investors can buy it for less than the face value.
For example, an investor who buys a bond at a discount of $920 will receive $1,000. The $80 return represents the investor's earnings or return on investment.
2. Corporate bonds
A corporate bond is a type of debt security that a company issues and sells to investors.
The company receives the capital it requires, and the investor receives a predetermined number of interest payments at either a fixed or variable interest rate.
When the bond "reaches maturity" or expires, the coupon payments stop, and the original investment (principal) is returned.
The bond is generally backed by the company's ability to repay, which is determined by its future revenue and profitability prospects. Physical assets of the company may be used as collateral in some cases.
3. Government bond
A government bond is a type of debt security issued by the government to fund its spending and obligations.
Government bonds issued by national governments are frequently regarded as low-risk investments because the issuing government guarantees them. Governments issue government bonds to raise funds for specific projects or day-to-day operations. The US Treasury Department auctions off the issued bonds throughout the year.
Some Treasury bonds are for sale on the secondary market. Individual investors can use this marketplace to buy and sell previously issued bonds through a financial institution or broker. Treasuries can be purchased through the US Treasury, brokers, and exchange-traded funds, which hold a portfolio of securities.
These are highly liquid short-term debt instruments with a rate of return. Because of their high liquidity, they are referred to as "cash equivalents" or "near cash."
Debt Securities vs. Equity Securities
Debt securities differ fundamentally from equities in structure, capital return, and legal considerations. Debt securities have a set term for principal repayment and an agreed-upon schedule for interest payments.
As a result, the yield-to-maturity, a fixed rate of return, can be calculated to forecast an investor's earnings. Investors have the option of selling debt securities before maturity, which may result in a capital gain or loss.
Debt securities are generally thought to be less risky than equities.
Equity has no fixed term, and dividend payments are not guaranteed. Dividends are paid at the company's discretion and vary depending on the performance of the business. Equities do not provide a fixed rate of return because there is no dividend payment schedule.
When investors sell their shares to third parties, they will receive the market value of their shares, and they may realize a capital gain or loss on their initial investment.
Investment in debt securities
There are numerous benefits to investing in debt securities. For starters, they are intended to repay investors' initial capital investment plus interest upon maturity. It's also worth noting that they provide guaranteed, regular payments through interest, resulting in a consistent stream of income.
1. Capital return
Investing in debt securities has numerous advantages. First, investors purchase debt securities to earn a return on their investment. Debt securities, such as bonds, are intended to provide investors with interest and capital repayment at maturity.
The repayment of capital is contingent on the issuer's ability to keep its promises; failure to do so will result in consequences for the issuer.
2. A consistent stream of income from interest payments
Interest payments on debt securities provide investors with a consistent stream of income throughout the year. They are guaranteed promised payments that can help the investor with cash flow needs.
3. Diversification methods
Debt securities can also be used to diversify an investor's portfolio, depending on their strategy. Investors can use such financial instruments to manage the risk of their portfolios, as opposed to high-risk equity
They can also stagger the maturities of multiple debt securities ranging from short to long term. It enables investors to customize their portfolios to meet their future needs.
Risks of Debt Securities
Debt securities are generally regarded as a less risky form of investment than equity investments such as stocks because the borrower is legally required to make these payments. Of course, as with all investments, the true risk of a particular security will depend on its specific characteristics.
For example, a company with a strong balance sheet operating in a mature market may be less likely than a startup operating in an emerging market to default on its debts. The mature company is more likely to receive a higher credit rating from the three major credit rating agencies: Standard & Poor's (S&P), Moody's Corporation (MCO), and Fitch Ratings.
Per the general risk-return tradeoff, companies with higher credit ratings typically offer lower interest rates on their debt securities and vice versa.
For example, according to the Bloomberg Barclays Indices of US Corporate Bond Yields as of July 29, 2020, double-A-rated corporate bonds had an average annual yield of 1.34 percent, compared to 2.31 percent for their triple-B-rated counterparts.
Because a double-A rating indicates a lower perceived risk of credit default, market participants are ready to accept a lower yield in exchange for these less risky securities.
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