Debt Security

What Is a Debt Security?

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.

Examples of debt securities include a government bond, corporate bond, certificate of deposit (CD), municipal bond, or preferred stock. Debt securities can also come in the form of collateralized securities, such as 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 type of financial asset that is 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 pre-established number of interest payments, along with the return of their principal upon the bond's maturity date.

Government bonds, on the other hand, are debt securities issued by governments and sold to investors. Investors lend money to the government in return for interest payments (called 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 their interest payments. Unlike equity investments, in which the return earned by the investor is dependent on the market performance of the equity issuer, debt instruments guarantee that the investor will receive repayment of their initial principal, plus a predetermined stream of interest payments.

Of course, this contractual guarantee does not mean that debt securities are without risk, since the issuer of the debt security could declare bankruptcy or default on their agreements.

Risk of Debt Securities

Because the borrower is legally required to make these payments, debt securities are generally considered to be a less risky form of investment compared to equity investments such as stocks. Of course, as is always the case in investing, the true risk of a particular security will depend on its specific characteristics.

For instance, a company with a strong balance sheet operating in a mature marketplace may be less likely to default on its debts than a startup company operating in an emerging marketplace. In this case, the mature company would likely be given a more favorable credit rating by the three major credit rating agencies: Standard & Poor’s (S&P), Moody’s Corporation (MCO), and Fitch Ratings.

In keeping with the general tradeoff between risk and return, companies with higher credit ratings will usually offer lower interest rates on their debt securities and vice versa. For example, as of July 29, 2020, the Bloomberg Barclays Indices of U.S. corporate bond yields showed that double-A-rated corporate bonds had an average annual yield of 1.34%, compared to 2.31% for their triple-B-rated counterparts.

Since the double-A rating denotes a lower perceived risk of credit default, it makes sense that market participants are willing to accept a lower yield in exchange for these less risky securities.

Debt Securities vs. Equity Securities

Equity securities represent a claim on the earnings and assets of a corporation, while debt securities are investments in debt instruments. For example, a stock is an equity security, while a bond is a debt security. When an investor buys a corporate bond, they are essentially loaning the corporation money, and have the right to be repaid the principal and interest on the bond.

In contrast, when someone buys stock from a corporation, they essentially buy a piece of the company. If the company profits, the investor profits as well, but if the company loses money, the stock also loses money.

In the event a corporation goes bankrupt, it pays bondholders before shareholders.

Example of a Debt Security

Emma recently purchased a home using a mortgage from her bank. From Emma’s perspective, the mortgage represents a liability that she must service by making regular interest and principal payments. From the perspective of her bank, however, Emma’s mortgage loan is an asset, a debt security that entitles them to a stream of interest and principal payments.

As with other debt securities, Emma’s mortgage agreement with her bank sets out the key terms of the loan, such as the face value, interest rate, payment schedule, and maturity date. In this case, the agreement also includes the specific collateral of the loan, namely the home which she purchased.

As the holder of this debt security, Emma’s bank has the option of either continuing to hold the asset or selling it on the secondary market to a company that might then package the asset into a collateralized mortgage obligation (CMO).