What Is a Debt Security? Definition, Types, and Trading
Demystify debt securities. Learn their core purpose, diverse structures, and how they are bought and sold in financial markets.
Debt securities represent a financial mechanism allowing entities to raise capital by borrowing money directly from investors. These instruments function as a loan agreement, where the issuer promises to repay the borrowed amount with interest over a specified period. Investors, by purchasing debt securities, act as lenders, providing funds to governments, corporations, or other organizations. This financing provides a structured way for borrowers to access capital, while offering investors a defined return.
Understanding the Basics of Debt Securities
A debt security is a financial instrument that signifies a loan made by an investor to a borrower. The principal, also known as the face value or par value, is the initial amount borrowed that the issuer promises to repay to the investor at the end of the loan term. Interest, often referred to as the coupon rate, represents the periodic payments made by the issuer to the investor for the use of their money. This interest can be fixed or variable, adjusting based on prevailing market rates. The maturity date is the predetermined future date when the principal amount of the debt security is repaid to the investor, marking the end of the loan period.
The issuer is the entity that borrows the money by issuing the debt security; this can include governments, corporations, or other public and private organizations. The investor is the individual or entity that lends the money by purchasing the debt security. The yield on a debt security is the total return an investor earns, accounting for both interest payments and any changes in the security’s market price until maturity.
Common Forms of Debt Securities
Bonds are a prevalent type, representing a loan made to a borrower, typically with a maturity period longer than one year.
Corporate bonds are issued by companies to finance operations, expansions, or acquisitions, offering investors periodic interest payments and the return of principal at maturity. These bonds can range in credit quality, with higher risk often correlating with higher potential yields.
Government bonds, such as U.S. Treasuries, are issued by national governments to fund public expenditures. Treasury bonds (T-bonds) have long maturities, typically 20 or 30 years, and pay interest semi-annually. Treasury notes (T-notes) are intermediate-term government debt securities with maturities ranging from two to 10 years, also paying interest every six months. Both are considered low-risk due to the backing of the U.S. government. Interest income from U.S. Treasuries is subject to federal income tax but is exempt from state and local taxes.
Municipal bonds are issued by state and local governments to finance public projects like infrastructure or schools. A significant feature of many municipal bonds is that the interest earned is often exempt from federal income tax and, in some cases, from state and local taxes if the investor resides in the issuing state. This tax advantage makes them attractive to investors, particularly those in higher tax brackets.
Commercial paper is an unsecured, short-term debt instrument typically issued by large corporations to meet immediate financing needs, such as payroll or inventory. Its maturity usually ranges from a few days to 270 days, and it is often issued at a discount rather than paying periodic interest. Only companies with high credit ratings can generally issue commercial paper at favorable rates.
Certificates of Deposit (CDs) are issued by banks, representing a deposit held for a fixed period at a fixed interest rate. CDs are considered low-risk investments because they are typically insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per depositor. Investors receive their principal back plus earned interest at the maturity date, though early withdrawals often incur penalties.
How Debt Securities are Traded
Debt securities are traded in two distinct markets: the primary market and the secondary market. The primary market is where new debt securities are initially issued by the borrower to investors. For government bonds, this often happens through auctions, where investors bid for the securities. Corporate bonds, conversely, are frequently issued through underwriting processes involving investment banks that help set terms and facilitate sales.
Once new debt securities are issued in the primary market, they can then be bought and sold among investors in the secondary market. This market provides liquidity for investors, allowing them to sell their holdings before the maturity date if needed. Most trading in the U.S. bond market, especially for corporate bonds, occurs in decentralized over-the-counter (OTC) markets rather than on traditional exchanges. This means transactions typically happen directly between dealers and large institutions.
The value of debt securities in the secondary market is influenced by several factors. Prevailing interest rates play a significant role; bond prices generally move inversely to interest rates. When interest rates rise, the value of existing bonds with lower fixed interest payments tends to fall, and vice versa. The creditworthiness of the issuer also impacts a security’s value. A higher perceived credit risk, indicating a greater chance of default, typically leads to lower prices and higher yields demanded by investors.