What is a debt security?
A gateway to capital for companies
You can find numerous examples of debt securities throughout the financial world. This type of borrowing refers to a contractual agreement between a borrower and a lender in which the borrower agrees to a repayment schedule with interest and repays the principal amount once the security reaches the maturity date.
Debt securities offer benefits to the borrower and the lender, or investor. It’s often seen as a low-risk option for investors and a way for a borrower, such as a company, to quickly raise capital.
A debt security is a loan between an investor and borrower, which entitles the investor to interest payments.
Jump to insightA company can use debt securities as a way of raising capital without having to give up any stakes in ownership.
Jump to insightDebt securities may provide a regular stream of income for investors, but there is always risk involved for a borrower and investor.
Jump to insightWhat 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.
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.”
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.
» MORE: What is a good investment?
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, town 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.
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.
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.”
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.
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.
Pros
- Can quickly raise capital in a variety of amounts, from large to small
- Potential return on investment
- Interest payments can provide regular stream of income for investors
- Can choose from range of maturity dates, including short-term and long-term
Cons
- May not enjoy higher returns compared with other investment options
- Offers lower liquidity, since debt securities are often harder to buy and sell
- Some corporate bonds carry a greater risk if a company declares bankruptcy
» MORE: Capital gains vs. investment income: how they differ
FAQ
How do debt securities generate income for investors?
Investors who purchase debt securities receive income from the interest payments from the issuer. Not only does the issuer make interest payments on a set timetable, but there’s also a specific maturity date when the principal must be repaid.
Where do you buy debt securities?
You can buy debt securities from a number of places, but it depends on the type of debt security you’re working with. If you’re buying a government bond, then you can purchase it directly from the U.S. government. Another option is working with a brokerage account, where a broker has access to a wide range of debt security options.
What is the difference between secured and unsecured debt securities?
A secured debt security means it’s backed by a form of collateral, which makes it less risky for an investor. An unsecured debt security doesn’t have any type of collateral and depends on the issuer’s creditworthiness, which creates more risk for an investor.
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.
Article sources
ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:
- FINRA, “Bonds.” Accessed May 21, 2024.
- Charles Schwab, “What Are Different Types of Investment Securities?” Accessed May 21, 2024.
