What is debt security?
A debt obligation refers to a debt instrument, such as a government bond, corporate bond, certificate of deposit (CD), municipal bond or preferred share, which can be bought or sold between two parties and whose basic terms are defined, such as the notional amount (borrowed amount), the interest rate as well as the maturity and renewal date. It also includes guaranteed securities, such as guaranteed debt securities (CDOs), guaranteed mortgage securities (CMOs), mortgage-backed securities issued by the Government National Mortgage Association (GNMA) and zero coupon securities.
Operation of debt securities
The interest rate on a debt security is largely determined by the borrower’s perceived repayment capacity; higher risks of default almost always lead to higher interest rates for borrowing capital. Also called fixed income securities, most debt securities are traded over the counter. The total dollar value of daily debt securities transactions is much higher than that of stocks, as debt securities are held by many large institutional investors, as well as by governments and non-profit organizations.
Difference between debt and equity securities
Equity securities represent a claim on the profits and assets of a company, while debt securities are investments in debt securities. For example, a share is an equity security, while a bond is a debt obligation. When an investor buys a corporate bond, he essentially lends money to the company and is entitled to be reimbursed the principal and interest on the bond. On the other hand, when someone buys shares of a company, he is essentially buying a piece of the business. If the company benefits, the investor also benefits, but if the company loses money, the action also loses money. In the event that the company goes bankrupt, it pays the bondholders before the shareholders.
While most people are more familiar with the equity market, the debt market is almost double its size globally. The global bond market is over $ 100 trillion, while the stock or stock market is worth around $ 64 trillion. In terms of daily trading volume, $ 700 billion in bonds contrasts with $ 200 billion in stocks. In most cases, debt securities are generally safer investments than equity securities.
Security of debt securities
Debt securities have an implied level of security simply because they guarantee repayment of the principal to the lender on the maturity date or when the security is sold. They are generally classified according to their level of default risk, the type of issuer and the income payment cycles. The more risky the bond, the higher its interest rate or yield.
For example, treasury bonds, issued by the United States Department of the Treasury, have lower interest rates than bonds issued by companies. Corporate and government bonds are however rated by agencies such as Standard & Poor’s and Moody’s Investors Service. These agencies rate, similar to the credit ratings given to individuals, and high-rated bonds tend to have lower interest rates than low-rated bonds. For example, historically, AAA corporate bonds have had lower yields than BBB corporate bonds.