Debt Security

Debt security refers to a debt instrument, such as a government bond, corporate bond, certificate of deposit (CD), municipal bond or preferred stock, that can be bought or sold between two parties and has basic terms defined, such as notional amount (amount borrowed), interest rate, and maturity and renewal date. It also includes collateralized securities, such as collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs), mortgage-backed securities issued by the Government National Mortgage Association (GNMAs) and zero-coupon securities.

The interest rate on a debt security is largely determined by the perceived repayment ability of the borrower; higher risks of payment default almost always lead to higher interest rates to borrow capital. Also known as fixed-income securities, most debt securities are traded over the counter. The total dollar value of debt security trades conducted daily is much larger than that of stocks, as debt securities are held by many large institutional investors as well as governments and nonprofit organizations.

Equity securities represent a claim on the earnings and assets of a corporation, while debt securities are investments into debt instruments. For example, a stock is an equity security, while a bond is a debt security. When an investor buys a corporate bond, he is essentially loaning the corporation money, and he has the right to be repaid the principal and interest on the bond. In contrast, when someone buys a stock from a corporation, he essentially buys a piece of the company. If the company profits, he profits as well, but if the company loses money, his stock also loses money. In the event that the corporation goes bankrupt, it pays bondholders before shareholders.

While most people are more familiar with the market for equity securities, the debt market is nearly twice its size, globally. The global bond market exceeds $100 trillion, while the stock or equity market is worth roughly $64 trillion. In terms of daily trade volume, $700 billion in bonds contrasts with $200 billion in stocks. In most cases, debt securities, on the whole, are safer investments than equity securities.

Debt securities have an implicit level of safety simply because they ensure that the principal amount that is returned to the lender at the maturity date or upon the sale of the security. They are typically classified by their level of default risk, the type of issuer and income payment cycles. The riskier the bond, the higher its interest rate or return yield.

For example, Treasury bonds, issued by the U.S. Treasury Department, have lower interest rates than bonds issued by corporations. Corporate and government bonds, however, are both rated by agencies such as Standard & Poor's and Moody's Investors Service. These agencies assign a rating, similar to the credit scores assigned to individuals, and bonds with high ratings tend to have lower interest rates than bonds with low ratings. For example, historically, corporate AAA bonds have lower yields than corporate BBB bonds.