What Is a Debt Security and How Does It Work?

A debt security represents a loan made by an investor to a borrower, such as a company or government. This financial instrument functions as a formal agreement where the issuer promises to repay the borrowed amount, known as the principal, along with interest payments over a specified period. Investors acquire these securities seeking predictable income streams and the return of their initial capital. Unlike owning a share in a company, purchasing a debt security does not confer ownership but rather establishes a creditor-debtor relationship.

What Defines a Debt Security

A debt security is characterized by several distinct features. Key components include a principal amount. Investors receive returns through interest payments, often referred to as coupon payments, which can be fixed or variable throughout the security’s life. These payments represent the cost of borrowing for the issuer and the income for the investor.

A defined maturity date indicates when the issuer must repay the principal. The obligation to repay both interest and principal is legally binding. Should the issuer face financial distress or bankruptcy, debt security holders generally have a higher repayment priority than equity holders, meaning they are paid before stockholders.

This structure contrasts sharply with equity securities, such as stocks, which represent ownership in a company and do not guarantee fixed returns or a return of the initial investment. Equity holders participate in the company’s profits through dividends and potential capital appreciation, but they also bear the full risk of loss and are last in line for repayment during liquidation.

Debt securities, being negotiable financial instruments, can be bought and sold between parties in the market before their maturity date, providing liquidity to investors.

Common Forms of Debt Securities

Bonds are a prevalent form, broadly categorized by their issuer. Corporate bonds are debt instruments issued by companies to raise capital for operations or expansion, typically offering higher interest rates than government bonds due to their increased credit risk.

Government bonds, including U.S. Treasury bills, notes, and bonds, are issued by the federal government and are considered among the safest investments because they are backed by the full faith and credit of the U.S. government. Treasury bills are short-term, maturing in a year or less, while Treasury notes have maturities ranging from two to ten years, and Treasury bonds extend to 20 or 30 years.

Municipal bonds are issued by state and local governments or their agencies to finance public projects like schools and infrastructure, and their interest is often exempt from federal income tax.

Certificates of Deposit (CDs) are another common debt security, representing a time deposit with a financial institution. CDs offer a fixed interest rate over a specified term and are generally considered low-risk, often insured by federal agencies up to a certain amount. While not always considered securities in the same vein as bonds, they share the core characteristic of a loan with a defined repayment schedule.

Notes, distinct from bonds primarily by their shorter maturity periods, are also issued by corporations and governments.

Who Issues Debt Securities

Governments, from federal to local, issue debt securities. The U.S. federal government issues Treasury securities to fund expenditures and manage national debt.

State and local governments issue municipal bonds for public infrastructure projects. This allows public entities to secure capital without relying solely on taxation.

Corporations also issue debt securities, primarily corporate bonds, to raise capital for new investments, expanding operations, or refinancing existing debt obligations.

How Debt Securities Generate Returns

The most common source of income is the periodic interest paid by the issuer, often semi-annually, known as coupon payments. This fixed or variable interest rate provides a predictable income stream for the investor.

Upon the debt security’s maturity date, the issuer repays the original principal amount back to the investor. This return of capital at maturity is a fundamental aspect of debt securities, ensuring the recovery of the initial investment.

Interest income earned from debt securities is generally subject to federal income tax, similar to ordinary income. However, certain exceptions exist, such as interest from municipal bonds which is often exempt from federal income tax, and Treasury securities whose interest is exempt from state and local taxes.

While the primary returns come from interest and principal repayment, debt securities can also be traded on secondary markets before maturity. Their market price can fluctuate based on factors like prevailing interest rates and the issuer’s creditworthiness. If an investor sells a debt security for more than its purchase price, they realize a capital gain, which is typically subject to capital gains tax. Conversely, selling below the purchase price would result in a capital loss.