What Is a Debt Security?
How Does a Debt Security Work?
An issuer, whether a corporation, municipality, state, or nation, will borrow money from investors by issuing or selling debt securities. Purchasers will receive a stated interest rate or coupon on a fixed basis. Interest payments are paid on a monthly, quarterly, semiannual, or annual basis depending on the terms of the issue.
As with any type of borrower, the interest rate paid on a debt security is determined by the creditworthiness of the issuer. The issuer receives a rating by credit rating agencies such as Standard and Poor’s, Moody’s or Fitch. Ratings will range from the AAA+ to DDD, which usually indicates that the issuer is in default (unable to pay interest or principal). Some small issues of debt securities may carry an “NR” designation which stands for “No Rating.”
Debt Securities vs. Equity Securities
Corporate debt securities differ from equity securities in that they rank higher in the capital structure of a company. An equity security, such as common stock, represents an actual ownership stake in the company and claim to any earnings or distributions in the form of dividends, spinoffs, or return of capital. However, in the event of bankruptcy and liquidation, equity holders have the last claim on the firm’s value.
Debt holders, on the other hand, hold a higher claim than equity holders in the event of bankruptcy and liquidation. While bank debt has the highest priority in claims, corporate debt holders typically receive something in the event of liquidation, based on the terms of the bond issue.
While most individual investors are much more familiar with equity (stock) markets, debt markets are much larger in comparison. In the United States, the total value of equity markets is just under $20 trillion while the domestic value for U.S. government treasury bonds alone is almost $40 trillion with an average daily trading volume of nearly $505 billion. These numbers are much larger on a global basis.
For individual investors, the choice between debt or equity securities is usually determined by their individual risk tolerance. Traditionally, more conservative investors will favor bonds (debt securities) over stocks (equity securities). They would rather trade lower market and asset price volatility for a fixed income payment. This is not to say that bond markets aren’t volatile. They can be. However, historically, equity markets move much faster. The trade off for investors willing to take that risk is the potential of a higher return.