What Is a Debt Security?

What are debt securities?

A debt security is a loan made by an investor to a borrower, typically a corporation or government agency. In exchange for raising capital, the borrower agrees to pay back the principal and interest over a fixed period.

"A debt security is an interest-bearing loan that investors can buy and sell. It could be a corporate bond backed by a company, or a government-backed bond," explained Joe Camberato, CEO of National Business Capital, a national fintech lending platform.

How debt securities work

A common example of how debt securities work is when corporations or government agencies issue bonds to investors. The investor can hold on to the bond until it fully matures, or they can choose to sell it to someone else.

Debt securities come with terms, including interest rate earned, when the issuer pays out interest payments, the maturity date and whether there’s an automatic renewal at the end of maturity period.

You can find different levels of risk among the various types of debt securities. Some types, such as government bonds, are typically considered lower-risk since they’re backed by the U.S. government, compared with corporate options, which can lose value if the company goes bankrupt.

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Types of debt securities

You can find a wide range of examples of debt securities. Some of the more common options include the following:

• Treasury bonds: Debt securities issued by the U.S. government with a fixed principal and long-term maturity dates ranging from 10 to 30 years.
• Treasury notes: Medium-term debt securities issued by the U.S. government with maturities ranging from two to 10 years.
• Corporate bonds: A type of bond corporations use for raising capital, with varying terms (anywhere from one to 30 years) and interest rates based on the issuer's creditworthiness. You can find secured, unsecured, guaranteed and convertible options under the corporate bond umbrella.
• Municipal bonds: States, cities, towns, villages and other local government entities can issue municipal bonds, which typically offer tax-exempt interest payments to investors.
• Government agency bonds: Also known as U.S. agency bonds, these are debt securities issued by government-sponsored enterprises (GSEs) like Fannie Mae or Freddie Mac. They typically support specific sectors like housing but are not backed by the U.S. government.
• Certificates of deposit (CDs): You may have heard a bank or credit union promoting a CD, which offers a fixed interest rate and a specific maturity date, typically ranging from a few months to several years.

Key debt security terms

Getting familiar with the specialized vocabulary around debt securities can help you make more informed investment decisions. Below, we define some common terms in this area of finance.

• Principal: Also known as par value or face value, this is the amount that the debt security issuer agrees to repay the buyer when the security matures. It is separate from interest payments.
• Interest: A debt security typically produces interest at a fixed rate, providing predictable income for the investor. The issuer makes periodic interest payments to the investor during the lifespan of the debt.
• Maturity date: This is the date when a debt’s principal and interest must be repaid in full to the investor.
• Issuer: The issuer of a debt security is the entity that originates and sells the security. Issuers are commonly corporations or governments.
• Callable: A callable debt is one that the issuer can redeem (fully pay off) before maturity.
• Convertible: A convertible security can be converted into another type of security, such as stock in the issuing company. Usually, the holder rather than the issuer decides if and when to convert the security.
• Secured/unsecured: Like personal loans, debt securities may be secured or unsecured. A secured debt is backed by some type of collateral, such as a company’s inventory, equipment or other property. An unsecured debt security relies on creditworthiness rather than collateral and is therefore considered higher risk.
• Covenants: Covenants are agreements that help protect bond holders by placing limitations or requirements on the bond issuer. For example, an issuer might be required to hold insurance or prohibited from changing its management without lender approval.

Debt securities vs. equity securities

Debt securities, like bonds and notes, represent loans made by investors to issuers. These securities provide fixed interest payments and repayment of the principal amount at maturity. They’re often considered lower-risk for both parties, and one of the biggest advantages is the issuer doesn’t have to give up any equity ownership in its business.

On the other hand, equity securities, such as stocks, mean the investor has ownership stake in a company. Investors with equity securities have entitlement to a share of the company's profits through dividends and potential capital gains. Equity securities typically have a higher risk because the returns depend entirely on the company's performance and market fluctuations.

“Investors buy debt securities for predictable income and lower risk compared to equity securities, while issuers use them to raise capital for various purposes like expansion, operations or refinancing existing debts,” Camberato says.

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Pros and cons of debt securities

Debt securities can offer tremendous benefits to a company, especially if it doesn’t want to give up any ownership control but still needs a source of funding. While debt securities usually offer a lower risk to the issuer and investor compared with other forms of investments, a company should carefully consider the benefits and drawbacks.

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Bottom line

Debt securities are one of many investment options available for investors, including those simply looking to diversify their portfolios. Debt securities offer numerous advantages as an investment, including low risk and a steadier stream of interest payments — although they’re not completely without risk.

You can purchase debt securities directly from the U.S. government (for government bond options), or you can work with a brokerage account that may have access to a wide range of debt security choices.