Debt security definition
/What is a Debt Security?
A debt security is any type of security that must be paid back in full to the investor, along with interest. The investor has the right to trade the security to a third party. The risk associated with a debt security is generally less than that of an equity security, since the amount on loan should eventually be paid back. Nonetheless, there is still a risk of nonpayment associated with debt securities, especially when the issuer is highly leveraged and is experiencing poor cash flows.
Governments and corporations are the common issuers of debt securities. Both types of entities do so in order to fund long-term projects, as well as to finance daily operations and pay down other debts.
Examples of Debt Securities
Several examples of debt securities are noted below:
Corporate bonds. A corporate bond is a debt security issued by a company to raise capital, with a promise to repay investors the principal amount at maturity along with periodic interest payments. For example, a company may issue a 10-year bond with a 5% annual coupon rate, meaning investors receive 5% interest payments annually until the bond matures. Corporate bonds can be investment-grade (lower risk) or high-yield (higher risk with higher returns).
U.S. treasury bonds. U.S. Treasury bonds (T-bonds) are long-term debt securities issued by the U.S. government to finance public spending. These bonds typically mature in 10 to 30 years and pay semiannual interest, making them a popular choice for conservative investors. Since they are backed by the federal government, Treasury bonds are considered one of the safest investments.
Municipal bonds. Municipal bonds (munis) are debt securities issued by state and local governments to finance infrastructure projects such as schools, highways, and water treatment facilities. Investors who purchase these bonds receive regular interest payments, which are often exempt from federal income tax and sometimes state taxes. Because of their tax advantages, municipal bonds are attractive to investors in higher tax brackets.
Mortgage-backed securities. A mortgage-backed security (MBS) is a type of debt security that pools together home loans and sells shares of the pooled loans to investors. Investors receive payments from the mortgage principal and interest collected from homeowners. MBS investments depend on the housing market's performance, and risks include prepayment risk (early loan repayments reduce expected returns) and default risk (borrowers failing to repay loans).
Certificates of deposit (CDs). A certificate of deposit (CD) is a debt security issued by banks and credit unions, where an investor deposits money for a fixed period in exchange for guaranteed interest. The terms can range from a few months to several years, and withdrawing funds early may result in a penalty. CDs are considered low-risk investments since they are typically insured by the FDIC up to a certain limit.
In each of these cases, the lender or investor is entitled to receive the full amount of the security at some later date, or to sell it now on a secondary market.
Terms Similar to Debt Security
A debt security is also known as a fixed-income security.