how debt securities work
a debt security is a type of financial asset that is created when one party lends money to another for example corporate bonds are debt securities issued by corporations and sold to investors investors lend money to corporations in return for a pre established number of interest payments along with the return of their principal upon the bond s maturity date 2government bonds on the other hand are debt securities issued by governments and backed by faith in that government which are sold to investors investors lend money to the government in return for interest payments called coupon payments and a return of their principal upon the bond s maturity 3debt securities are also known as fixed income securities because they generate a fixed stream of income from their interest payments unlike equity investments in which the return earned by the investor is dependent on the market performance of the equity issuer debt instruments guarantee that the investor will receive repayment of their initial principal plus a predetermined stream of interest payments 4of course this contractual guarantee does not mean that debt securities are without risk since the issuer of the debt security could declare bankruptcy or default on their agreements risks of debt securitiesbecause the borrower is legally required to make these payments debt securities are generally considered to be a less risky form of investment compared to equity investments such as stocks of course as is always the case in investing the true risk of a particular security will depend on its specific characteristics 5for instance a company with a strong balance sheet operating in a mature marketplace may be less likely to default on its debts than a startup company operating in an emerging marketplace in this case the mature company would likely be given a more favorable credit rating by the three major credit rating agencies standard poor s s p moody s corporation and fitch ratings in keeping with the general tradeoff between risk and return companies with higher credit ratings will usually offer lower interest rates on their debt securities and vice versa for example as of july 2023 moody s seasoned aaa corporate bond yield is 4 66 whereas its seasoned baa corporate bond yield is 5 74 67since the aaa rating denotes a lower perceived risk of credit default it makes sense that market participants are willing to accept a lower yield in exchange for these less risky securities debt securities vs equity securitiesequity securities represent a claim on the earnings and assets of a corporation while debt securities are investments in debt instruments for example a stock is an equity security while a bond is a debt security when an investor buys a corporate bond they are essentially loaning the corporation money and have the right to be repaid the principal and interest on the bond in the event a corporation goes bankrupt it pays bondholders before shareholders in contrast when someone buys stock from a corporation they essentially buy a piece of the company if the company profits the investor profits as well but if the company loses money the stock also loses money 