Table of Contents
- What Are Debt Securities?
- Debt Securities vs. Equity Securities
- Features of Debt Securities
- Examples of Securities
- Benefits of Debt Securities
- Risks of Debt Securities
- Lesson Summary
Debt securities is a financial term used to describe the debts that can be purchased or bought amongst market players before they attain maturity. They are financial instruments that have the promise of payment by the issuer to the holder at an agreed amount of money at a particular time, which is usually the point of maturity of the financial instrument. They can also be described as financial assets used to raise an entity's debt upon being invested. Therefore, debt securities are precisely a representation of borrowed money that is due for payment at a particular interest rate based on the loan size and the maturity or renewal date.
Debt securities have a negotiability feature which makes their transferability easy amongst parties. Private investors or the government buys debt securities since they are usually in large sizes, with the expectation of repaying the principal amount alongside a periodic interest. The sale of debt securities is helpful to the government or investors as it enables them to raise funds for various projects like a business expansion for business owners and the provision of public services by the government. For instance, the U.S government-issued debt securities in the form of bonds when World War II was taking place in a bid to garner funds for military support.
Therefore, the issuance of debt securities is tied to the need to raise funds by investors or the government. This is because debt security, like a bond, acts as a loan grant between two parties, the investor and the entity purchasing it, where the investor gives the buying entity an amount of money payable after an agreed period, and the investor is repaid periodically at a given interest rate.
Equity securities vary in many ways from debt securities. Both are financial securities but are different from each other in their features, examples, and many other ways. Below are some of the differences between both financial securities.
Securities are categorized into two distinct forms; debt and equity. Debt securities are subdivided into government, corporate, and municipal bonds. Government bonds are loan grants or financial obligations that the national government provides for use as a source of funding for the expenses of the government. Government bonds have the backing of the federal government in full faith and credit, which means that the government pledges to pay the obligation on time. Government bonds usually depict lesser interest in comparison to corporate bonds because of the minimal default risk. Examples of these are treasury notes, treasury bills, zero-coupon bonds, municipal bonds, and treasury bonds.
Corporate bonds describe the securities that corporations issue to willing buyers. Corporate bonds depict higher interest rates than U.S government bonds due to the higher risk of default associated with them. The credit rating determines the interest rate to be charged because it shows the subsequent default risk. Examples of these are convertible bonds, callable bonds, junk bonds, and investment-grade bonds.
Municipal bonds fall under the category of government bonds because they are issued by both state and local governments. The risk associated with them is higher in comparison to the federal government's bonds. However, the expected yield is usually higher than that of the federal government bonds.
On the other hand, equity securities are categorized into mutual funds, certificates of deposit, and stocks. Stocks are further divided into preferred stock and common stock. Preferred stock describes the shares of stock in a particular company that shareholders receive as dividends. In contrast, common stock is the share of ownership in a company where shareholders have voting rights or a platform to contribute to the entity's decision-making. Therefore, preferred stock has fixed dividends with no voting rights, unlike common stock.
Certificates of deposit are savings accounts in which account holders deposit a fixed amount of money for a fixed period, and the bank pays interest to the customer in return. Banks prefer that customers deposit their money in certificates of deposit and not in the usual savings accounts because the customers can only invest in CDs for a fixed period so that the bank can use the money for fractional banking.
Debt securities are beneficial to investors because they provide repayment of what they initially invested, the principal amount, and additional interest when the security matures. Additionally, debt securities enable investors to diversify their portfolios hence mitigating risk effectively. Debt securities also act as a steady flow of income to investors because they guarantee consistent interest payments as repayment for their initial investment.
Debt securities are associated with default risks whereby the bond issuer fails to meet their debt obligations on time by making the agreed interest payments and the principal amount. Though some entities may come up with ways of managing default risks, they are bound to take time and costs while following up on the proceedings.
Debt securities are also faced with the interest rate risk, which refers to the abrupt change in interest rate in the market hence affecting the expected return by investors.
The reinvestment rate risk is also another risk affecting debt securities. It describes the instance when the interest rate falls and makes it impossible to reinvest the investment proceeds in the form of interest and coupon returns.
Debt securities are described as financial obligations where investors buy the securities and expect to receive periodic payments in the form of interest and the principal amount after a particular period known as the maturity date. Debt securities are characterized by a yield to maturity, maturity date, coupon rate, and an issue price and date. Securities are grouped into debt and equity. Examples of debt securities are government bonds and corporate bonds. Government bonds portray a lesser interest rate than corporate bonds because they have little or no default risk because they are backed by the credit and full faith of the federal government. An example of a government bond is the municipal bond which is granted by both local and state governments. Debt securities are beneficial because they provide a stream of income to investors through regular interest payments. They also aid in the portfolio diversification by investors hence mitigating risk. However, these securities are faced with default risks, interest risks, and reinvestment rate risks.
Examples of equity securities are certificates of deposit and stocks. Certificates of deposit are the savings accounts in banks where customers store a fixed amount of money for a fixed period. Banks prefer them to simple savings accounts because they can use them to generate money through fractional reserve banking and later pay the customers with interest. Stocks are further subdivided into preferred and common stocks, which differ in the aspect that preferred stocks have fixed dividends and have no voting rights, but common stocks have voting rights where shareholders can influence the decisions of the company, including the due dividends.
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Debt securities are categorized into corporate bonds, municipal bonds, government bonds, treasury bonds, treasury notes, treasury bills, commercial paper, certificate of deposit, and savings bonds.
Debt securities are issued as loans to entities seeking to raise funds as a source of garnering money for projects or public service provision, in the case of the government.
Bonds are deemed debt securities because they involve the issuance of bonds by borrowers to willing investors. These might be corporations or governments aiming at raising funds and repayment is to be done after a fixed period.
Debt securities are a good investment because they provide regular periodic payments to investors. This enables investors have a steady flow of income. They also provide for portfolio diversification to investors which is good for risk mitigation.
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