Where to Buy Debt: A Breakdown of Your Options

Debt Instruments for Purchase

When individuals buy debt, they acquire financial instruments representing a loan made to a borrower. These instruments obligate the borrower, whether a government, corporation, or other entity, to repay the principal amount along with interest over a specified period. Each instrument has distinct characteristics based on its issuer and structure.

Government bonds, such as U.S. Treasury bills, notes, and bonds, are debt obligations issued by the federal government to finance spending. Treasury bills mature in one year or less, notes mature between two and ten years, and bonds mature in over ten years. These securities have a low risk of default because they are backed by the full faith and credit of the U.S. government.

Corporate bonds are debt securities issued by companies to raise capital. These bonds represent a loan from the investor to the corporation, with the company promising to pay interest over a set period and return the principal at maturity. Terms like interest rates and repayment schedules are outlined in the bond’s indenture, a legal contract between the issuer and bondholder.

Municipal bonds are debt securities issued by state and local governments and their agencies to finance public projects like schools, roads, or airports. Interest earned on these bonds is often exempt from federal, and sometimes state and local, income taxes. This tax-exempt status attracts investors in higher tax brackets.

Mortgage-backed securities (MBS) represent claims to cash flows from a pool of mortgage loans. Investors in MBS receive payments from homeowners’ mortgage principal and interest. These securities allow investors to gain exposure to the housing market without directly owning individual mortgage loans, providing diversification and liquidity.

Asset-backed securities (ABS) are similar to MBS but are backed by other asset types, such as auto loans, credit card receivables, or student loans. They transform illiquid assets into marketable securities, allowing originators to free up capital and investors to gain exposure to various consumer and commercial credit sectors. The cash flows from the underlying assets pass through to ABS holders, providing regular income.

Distressed debt refers to debt instruments of companies or governments facing financial difficulties, default, or near-default. It trades at a significant discount to its face value due to the high risk of the borrower’s uncertain financial future. Investing in distressed debt involves a specialized understanding of bankruptcy laws and corporate restructuring processes.

Acquiring Newly Issued Debt

The primary market is where debt instruments are first offered to the public. This involves direct transactions between the issuer and initial investors, often facilitated by financial institutions. Methods for acquiring new debt vary by bond type.

For U.S. government bonds, new issues are acquired through U.S. Department of the Treasury auctions. Investors can participate directly through TreasuryDirect, an online platform, or via a commercial bank or broker. In competitive bidding, investors specify the yield they accept, while non-competitive bids guarantee purchase at the average auction price, simpler for individual investors.

New corporate bonds come to market through investment banks acting as underwriters. Underwriters purchase the entire bond issue from the corporation and resell them to institutional and individual investors. Individual investors access these issues through brokerage firms, which may be part of the underwriting syndicate or have access to the offering. The offering price and initial interest rate are determined during this process.

Municipal bonds are also issued through competitive bids and negotiated sales. In competitive bids, the issuer solicits bids from underwriting syndicates, awarding bonds to the syndicate offering the lowest interest cost. Negotiated sales involve the issuer directly selecting an underwriter to structure and sell bonds. Individual investors usually purchase new municipal bonds through brokerage firms specializing in or having access to these primary market offerings.

Trading Existing Debt

Beyond acquiring newly issued debt, investors can also buy and sell debt already circulating in financial markets. This occurs in the secondary market, providing liquidity and allowing investors to trade bonds before maturity. Unlike stocks, which trade on centralized exchanges, most bond trading occurs in a decentralized over-the-counter (OTC) market.

The OTC market for bonds operates through a network of broker-dealers who buy and sell bonds directly with each other and clients. When an investor wants to buy or sell an existing bond, they contact a broker-dealer who searches for a counterparty. Prices are negotiated directly, and the broker-dealer facilitates the transaction, often earning a commission or spread. This decentralized nature means bond prices can vary slightly between dealers.

Electronic trading platforms have emerged to enhance efficiency in the bond market, especially for institutional investors. These platforms aggregate bids and offers from multiple dealers, providing transparency and faster trade execution. While primarily used by large financial institutions, some retail brokerage firms offer clients access or use them internally to source bonds.

Individual investors commonly trade existing bonds through online or full-service brokerage accounts. Brokerage platforms provide access to a wide range of bonds in the secondary market, allowing investors to search for specific issues, view current prices, and place orders. When placing an order, investors specify the bond’s CUSIP number, issuer, maturity date, and desired quantity, and the broker seeks to execute the trade in the OTC market.

Some peer-to-peer (P2P) lending platforms also offer a secondary market for loans. While their primary function is to originate new loans, certain platforms allow investors to sell existing loan participations to other investors. This provides liquidity for investors wishing to exit positions before loans are fully repaid. Availability and liquidity of such secondary markets vary significantly across P2P platforms.

Pooled Investment in Debt

For many general investors, gaining exposure to debt is most accessible through pooled investment vehicles rather than direct purchases of individual bonds. These vehicles collect money from numerous investors and invest it in a diversified portfolio of debt securities. This approach offers diversification, professional management, and often lower minimum investment requirements compared to buying individual bonds.

Bond mutual funds are professionally managed portfolios that invest in a variety of debt securities like government, corporate, or municipal bonds. Investors purchase shares in the fund, and the fund’s value fluctuates based on its underlying bond holdings. These funds provide instant diversification across many bonds, mitigating the risk of any single bond default. Investors typically buy and sell shares directly through the fund company or a brokerage firm at the fund’s net asset value (NAV) at the end of each trading day.

Bond exchange-traded funds (ETFs) are similar to mutual funds, holding a portfolio of bonds, but trading on stock exchanges throughout the day like individual stocks. This allows investors to buy and sell shares at market prices, which fluctuate based on supply and demand. Bond ETFs offer similar diversification and professional management benefits as mutual funds, with the flexibility of intraday trading and often lower expense ratios.

Closed-end funds (CEFs) focusing on debt are another pooled vehicle. Unlike mutual funds, CEFs issue a fixed number of shares through an initial public offering (IPO) and trade on stock exchanges. Their market price can deviate from their net asset value (NAV), trading at a premium or discount. CEFs often invest in specialized or less liquid bond markets, providing access to segments difficult for individual investors to reach directly.

Unit investment trusts (UITs) offer a distinct approach to pooled debt investing. A UIT holds a fixed portfolio of debt securities, unchanged for the trust’s life, typically one to five years. Investors purchase units in the trust and receive income payments from the underlying bonds. Unlike mutual funds, UITs are not actively managed; once assembled, no changes are made unless a bond defaults. Upon termination, investors receive a proportionate share of the remaining principal.