What Are Debt Securities & How They Work? Overview & Types
Debt securities are business assets in the form of a debt that may be sold and purchased. The buyer of a debt security is entitled to interest payments made to the correlating account. To put it simply, an investor lends money to a business or government entity with the promise of a higher payout when the bond matures.
Here’s What We’ll Cover:
Most Common Types of Debt Securities
A government bond is also called a treasury bond. The Australian government issues two types of treasury bonds. The first is an Exchange-traded Treasury Bond (eTB) and the second is an Exchange-traded Treasury Indexed Bond (eTIB).
Companies often issue corporate bonds as a way of raising money from investors. The bond is a promise to pay back the loan amount with interest. When it comes to corporate bonds, there is always a risk that the business could fail, leading to a corporate bond default for investors.
A municipal bond is similar to a government bond, but instead of being issued at a federal level, states, cities, and other localities issue the bonds. When purchasing a municipal bond, you know the term and interest rate in advance.
Also called a CBO, collateralized bonds are an investment into a pool of "junk" bonds. Individually, the bonds are very risky as an investment. High-yield bonds and low-yield bonds are paired together in a group. Together, the pool offers enough diversity to be worthy of investment.
A zero-coupon bond works differently than other types of bonds. Instead of earning an interest rate, you purchase a bond with a set value, but you purchase it at a discount. You know exactly how much you'll earn because the borrower pays back the full face value, no matter the discount you receive.
Debt Securities Vs Equity Securities
The opposite of debt security is equity security. Think, the stock market. Equity securities are highly volatile and subject investors to a high amount of risk. Investing in a company at $100 per share means that you can double your money if the share price reaches $200 or lose it all if a company goes bankrupt. Equity securities are the riskiest investment options. With the possibility of higher returns comes greater risk.
Debt securities, on the other hand, are much more secure investment options. They offer much lower returns than their equity counterparts but are safer investment options because investors rarely lose money. Additionally, bonds offer predictability when it comes to creating a stream of income. For example, government-issued bonds pay every six months.
Other key differences include:
- Debt securities have a defined maturity date, while equity securities do not.
- Equity securities represent ownership, while debt securities are simply a loan.
- Debt securities offer a fixed rate of return, and equity securities are variable.
Why Invest in Debt Securities?
Debt securities offer a higher return on your money than a savings account or certificate of deposit at a traditional bank. Still, debt securities are not without risk. Debt securities are a legally binding agreement in which a business or governmental entity agrees to pay you a certain amount or rate. Some debt securities are more secure than others.
For example, a startup company is a riskier investment option than a well-established business with a proven track record. Both types of companies issue debt securities. Startups may offer a higher rate of return in exchange for the inherent risk. Established companies may offer a lower rate of return if they have strong balance sheets that prove their financial history.
Diversifying Investment Portfolios
Each investor has different investment goals and risk tolerance. Conservative investors that prefer to avoid risk may place a majority of their funds in debt securities like bonds. Keep in mind that even with conservative investments, there is room to take risks on higher-yield bonds.
An investor seeking aggressive growth may place a majority of their funds in the stock market and limit debt securities to 15% or less of their portfolio. No matter what your risk tolerance, a diversified portfolio helps to protect against risk.
Investors generally consider debt securities to be safe, low-risk options. They're also a great way to defer tax payments until later in life, like during retirement. Before choosing a single type of debt security, research each one to see which type meets your investment needs. You can even diversify your portfolio within the realm of debt securities by investing in various types of debt securities.
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