A debt security is basically like an asset created when a party lends money to another. We can see an example of this in corporate bonds. Corporate bonds are debt securities that corporations issue and sell to investors. There are other examples of debt securities, like government bonds, municipal bonds, and certificates of deposit, to mention but a few. Let’s see what this term entails in general:
What Are Debt Securities?
A debt security is a debt instrument that can be purchased or sold between two parties. It defines fundamental terms such as the notional amount (the amount borrowed), interest rate, maturity, and renewal date.
A government bond, corporate bond, certificate of deposit (CD), municipal bond, or preferred stock are all examples of debt securities. Debt securities can also take the form of collateralized securities. Such securities can be collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs), mortgage-backed securities issued by the Government National Mortgage Association (GNMA), and zero-coupon securities.
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 firms and sold to investors. Investors lend money to firms in exchange for a set number of interest payments and the return of their investment when the bond matures.
Government bonds, on the other hand, are debt securities sold to investors by governments. Investors lend money to the government in exchange for interest payments (called coupon payments) and a return of principal upon the maturity of the bond.
Debt securities are sometimes known as fixed-income securities because their interest payments provide a consistent stream of income. Unlike equity investments, where the investor’s return is contingent on the equity issuer’s market performance, debt instruments guarantee that the investor will get repayment of their initial principal plus a fixed stream of interest payments.
In fact, this contractual guarantee does not mean that debt securities are risk-free. This is because the debt security’s issuer may declare bankruptcy or default on its obligations.
Debt Securities Risks
Debt securities are generally seen as a less dangerous form of investment than equity investments like stocks. This is mainly because the borrower is legally compelled to make these payments. Of fact, as with other investments, the true risk of a particular security will depend on its individual characteristics.
A company with a robust balance sheet operating in an established market, for example, may be less likely to default on its loans than a startup operating in an emerging market. The three major credit rating agencies, Standard & Poor’s (S&P), Moody’s Corporation (MCO), and Fitch Ratings, would likely assign the mature company a more favorable credit rating in this situation.
In accordance with the general risk-return tradeoff, corporations with higher credit ratings would typically provide 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.
Market participants are ready to accept a lower yield in exchange for these less risky securities. This is because a double-A grade indicates a lower perceived risk of credit default.
Equity Securities vs. Debt Securities
Equity securities reflect a claim on a corporation’s earnings and assets, whereas debt securities are investments in debt instruments. A stock, for example, is an equity security, whereas a bond is a debt security. When an investor purchases a corporate bond, they are essentially lending money to the firm and have the right to be reimbursed the bond’s principle and interest.
In contrast, when a person purchases stock from a corporation, they are essentially purchasing a piece of the company. If the company makes money, the investor makes money as well; if the company loses money, the stock also loses money.
In the event that a corporation declares bankruptcy, bondholders get paid before shareholders.
In a nutshell, these are the differences between debt securities and equity securities:
- Equity securities represent corporate ownership, whereas debt securities represent a loan to the corporation.
- Equity securities do not normally have a maturity date, whereas debt securities do.
- Dividends and capital gains are variable returns on equity securities, whereas interest payments are fixed returns on debt securities.
- Both securities are issued at face value and trade at market value. This market value could be greater or less than the face value.
- Shareholders of equity have voting rights, whereas holders of debt securities do not.
General Characteristics of Debt Securities
Most debt securities share several fundamental characteristics. They are issued as a transferable instrument, and they bear interest. They are also offered at a discount to their face value.
Although some debt securities are issued without a fixed redemption date (perpetual securities), they can be: listed on a stock exchange or issued to a pre-selected group of investors on a private placement basis. They are typically traded over-the-counter (OTC), ie directly between two parties rather than via a stock exchange (even if they are listed).
They can be unsecured and rank on par with the issuer’s other unsecured debt, or secured on specific assets, and they can be:
Full recourse indicates that holders of the securities have a claim on the issuer’s general assets, whereas limited recourse means that holders of the securities’ claims are limited to designated assets of the issuer.
Examples Of Debt Securities
Some of the most common examples of debt securities are as follows:
#1. Bonds, notes, and medium-term notes
Bonds and notes can be issued as a one-time event or as part of a recurring scheme. Medium-term notes, or MTNs, are those issued as part of a program. This enables an issuer to make several issues based on a single primary set of documents. This saves both time and money for the issuer.
#2. Commercial paper (CP)
This is a type of short-term debt instrument. In this context,’short-term’ denotes it has a period of fewer than 365 days when granted in the United Kingdom. In the US market, other rules apply.
#3. Interest-Paying Securities
Most debt securities need interest payments to be made on a regular basis.
Interest on a debt security, like interest on a loan, can be fixed, floating, or variable.
#4. Zero-Coupon Securities
Zero-coupon securities bear no interest and are instead issued at a discount to their face value.
When the investor redeems the security, the issuer repays the full face value of the security. The difference between the issue price and the full face value of the security received from the issuer upon redemption represents the investor’s return.
#5. High Yield Securities
High yield securities, often known as high yield bonds, are issued by non-investment grade issuers and are occasionally subordinated to the issuer’s other specified debts. To reflect their riskier character, they pay higher interest rates than investment-grade bonds. They are often issued to assist in the financing or refinancing of a corporate acquisition and are normally subordinated to the issuer’s other debts.
Under US securities rules, high yield bonds are considered securities. As a result, preparing a high yield bond offering requires significantly more work than preparing a facility agreement. A disclosure document, also known as an offering memorandum, must be created. It must include specific information about the issuer’s business, management’s discussion and analysis of the financial status and results of operations, risk factors, and a description of the notes. The preparation of the offering memorandum involves the issuer, its counsel, the underwriters and their counsel, and the auditors.
#6. Equity-linked securities
Equity-linked securities grant the investor certain share-related rights and hence share some of the characteristics of equity securities if those rights are exercised.
The following are the primary categories of equity-linked securities:
- Convertible securities which enable investors to convert their debt securities into shares of the issuer at a set time and price.
- Exchangeable securities which allow an investor to convert debt securities into shares in a third-party firm at a set time and price. and warrants—these provide the investor the option to purchase the issuer’s shares or bonds at a certain price.
Warrants are tradable securities that offer the holder the right, but not the duty, to buy or sell a certain asset (the underlying asset or simply underlying) at a specific price (the exercise price or strike price) on a specific day or date (the exercise date(s)).
A warrant is a type of derivative that derives its value from the underlying asset and is a way to gain exposure to the underlying asset’s value without owning it. Warrants are frequently referred to as securitized derivatives, which are derivatives that take the form of securities.
A warrant is not a debt security. Therefore, it does not have a principal amount, no repayment covenant, and does not bear interest.
#8. Asset-backed Securities
Asset-backed securities (ABSs) are debt securities with limited recourse issued by a special purpose vehicle (SPV) and backed by income-producing financial assets (eg mortgages, loans, or receivables, often together with a derivative). The cash flows generated by the financial assets will be used by the SPV to pay principal and interest on the ABSs. As part of a structured financing or securitization transaction, ABSs can be constructed in a variety of ways. ABSs are often collateralized by the underlying financial assets.
#9. Covered Bonds
Covered bonds are asset-backed securities that have the following characteristics:
- They are issued by banks or other mortgage lenders and are secured by a pool of mortgages or government debt (the asset pool)
- Because the asset pool is dynamic rather than static, assets that have been redeemed or defaulted can be replaced with new assets.
- Bondholders have recourse to both the bond issuer and the pool of assets. The bonds are issued under a statutory and/or regulatory regime designed to ensure that: the asset pool is separate from the issuer’s other assets, and that the asset pool is sufficient to cover repayment of the covered bonds.
- Bondholders have a claim on the asset pool that is unaffected by the issuer’s default or insolvency.
#10. Government bonds
Sovereign bonds are debt securities issued by governments, either in their native securities markets or in international securities markets.
The fundamental issue that arises when sovereigns of lower credit grade issue debt securities is how the holders of the securities will be handled if the sovereign is compelled to reschedule its debts.
Are Bonds and Debt Securities The Same?
A bond, like an IOU, is a debt security. Borrowers create bonds to raise funds from investors who are ready to lend them money for a set period of time. When you purchase a bond, you are making a loan to the issuer, which could be a government, municipality, or corporate.
Generally, investing in debt securities is less risky than investing in equity securities. Bonds are less volatile in the market. Bond values fluctuate with interest rates, but they have a fixed value at maturity. Bond risks include the issuing business becoming bankrupt and unable to satisfy its obligations, the bond’s value fluctuating owing to interest rate changes, and, in some situations, the bond is called prior to maturity. In the event that a corporation declares bankruptcy, bondholders must be paid before stockholders are paid.
Debt Securities FAQs
What are the four main types of debt securities?
The types of debt securities include corporate bonds, municipal bonds, treasury bonds, and government bonds.
Are debt securities safe?
Debt securities, for example, corporate bonds, are not entirely safe. Corporate bond funds that invest in high-quality debt products can better suit your financial goals.