What it means
The word that does the work here is "security", meaning an investment that is standardised enough to change hands in a market. A private bank loan and a listed bond may both be borrowings, but only the bond can be sold to a stranger on a Tuesday afternoon.
For the issuer, debt securities are a way to borrow from thousands of lenders at once instead of negotiating with one bank. That widens the pool of available money and often lowers the rate, which is why large borrowers use the bond market heavily.
For the investor the appeal is predictability. A debt security promises stated interest payments and the return of the face value at maturity, which sits well alongside shares in a portfolio because the two behave differently.
Price and yield move in opposite directions, and this trips people up constantly. If a security paying a fixed $50 a year can be bought for less than its face value, the buyer earns a higher percentage return, so falling prices mean rising yields.
Risk comes in two main forms. Credit risk is the chance the issuer fails to pay, which is why rating agencies grade issuers, and interest rate risk is the chance that market rates rise and make an existing fixed payment look unattractive.
Accounting treatment depends on intent. A business that plans to hold a security to maturity may carry it at cost, whereas one that trades securities must usually mark them to market, and that difference changes how reported profit moves.
In practice
Real-world examples.
Example
A pension fund buys $12,000,000 of ten-year government bonds to match payments it must make to retirees in a decade. The predictable coupons matter more to the fund than the chance of capital growth.
Example
A utility issues $300,000,000 of bonds to build a substation. Because its revenue is regulated and stable, it borrows at a materially lower rate than a technology company of the same size could.
Example
A corporate treasurer parks $5,000,000 of surplus cash in three-month treasury bills rather than a current account. The bills are highly liquid, so the money can be raised again quickly if a supplier payment falls due.
Formula
Calculation
Current yield = Annual coupon payment / Market price. Annual coupon payment = Face value x Coupon rate.
A corporate bond has a face value of $1,000 and a coupon rate of 5%, so it pays 5% x $1,000 = $50 a year. Because market interest rates have risen since it was issued, it now trades at $800. Its current yield is $50 / $800 = 6.25%, well above the 5% coupon printed on the certificate. An investor buying 200 of these bonds pays 200 x $800 = $160,000 and receives 200 x $50 = $10,000 a year, confirming a yield of $10,000 / $160,000 = 6.25%. If the issuer repays face value at maturity, the investor also collects a gain of $200 per bond.Case study
Seen in the real world.
Marrowdale Water Authority is an illustrative, fictional municipal utility used here to show how debt securities work from both sides. It needed $50,000,000 to replace ageing pipework and chose to issue twenty-year bonds at a 4% coupon rather than borrow from a single bank.
The issue was bought by insurance companies and retail investors attracted by steady, predictable income. Marrowdale committed to paying $2,000,000 of interest each year and repaying the face value in year twenty, and it recorded a single long-term liability while hundreds of investors recorded individual assets.
Five years into this fictional example market rates rose sharply, and the bonds traded down to around $850 per $1,000 of face value. Marrowdale's cash cost did not change at all, because its coupon was fixed, but investors who wanted to sell early took a loss while new buyers picked up a higher yield. That gap between the issuer's fixed cost and the investor's changing return is the single most useful thing to understand about debt securities.
Watch out
Common mistakes.
- Believing debt securities cannot lose money. Prices fall when interest rates rise or the issuer weakens, and selling before maturity can crystallise a real loss.
- Confusing the coupon with the yield. The coupon is fixed against face value, while the yield depends on the price actually paid.
- Assuming a government security is risk free. Default risk may be very low for major issuers, but interest rate risk and inflation risk still apply.
Questions
People also ask.
What is the difference between a bond and a debt security?
A bond is the most common type of debt security; the wider term also covers notes, bills and commercial paper.
Why would a company issue securities instead of taking a loan?
Issuing spreads the borrowing across many investors, often at a lower rate and with fewer day-to-day restrictions than a bank facility.
Are debt securities safer than shares?
They rank ahead of shares if the issuer fails and their returns are more predictable, but safer is not the same as safe.
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