Debt Security
Definition
A debt security is a financial instrument representing a loan made by an investor to a borrower, typically a corporation or government. Debt securities must be repaid at maturity and usually come with a fixed interest rate or an original purchase discount.
Key Characteristics
- Principal Amount: The borrowed amount that must be repaid by the issuer at maturity.
- Maturity: The specific date by which the principal amount must be repaid.
- Interest Rate: The fixed or variable rate paid by the borrower to the investor for the borrowed funds.
- Original Issue Discount: The difference between a bond’s face value and its lower price at issuance, providing a form of interest to the holder.
Examples
- Bills: Short-term debt instruments issued by the government with maturities of one year or less.
- Bonds: Long-term debt instruments with maturities exceeding one year, often issued by corporations or governments.
- Commercial Paper: Unsecured, short-term debt issued by corporations to meet immediate financing needs, typically with maturities of up to 270 days.
- Notes: Debt securities with intermediate maturities, generally between one and ten years.
Frequently Asked Questions (FAQs)
Q1: What is the difference between a bond and a note?
A1: A bond typically has a longer maturity (more than ten years), while a note usually has a maturity period between one and ten years.
Q2: How does a debt security differ from equity security?
A2: Debt securities represent borrowed money that must be repaid, whereas equity securities represent ownership in a company and generally do not have a maturity date.
Q3: Can debt securities be traded in the secondary market?
A3: Yes, debt securities can often be bought and sold in secondary markets, allowing investors liquidity.
Q4: What is meant by the “yield” of a debt security?
A4: The yield is the rate of return on a debt security, reflecting the interest earnings relative to the security’s current market price.
Q5: What is credit risk in the context of debt securities?
A5: Credit risk refers to the risk that the issuer might default on its obligation to pay interest or repay the principal.
- Maturity: The expiration date of a debt security when the principal amount must be repaid.
- Interest: The periodic payment made by the borrower to the lender, usually expressed as an annual percentage of the principal.
- Commercial Paper: Short-term unsecured promissory notes issued by companies.
- Discount: The amount by which a debt security’s purchase price is lower than its face value.
Online References
Suggested Books for Further Study
- “The Bond Book” by Annette Thau
- “Debt Markets and Analysis” by R. Stafford Johnson
- “Fixed Income Analysis” by Barbara S. Petitt and Jerald E. Pinto
Fundamentals of Debt Security: Finance Basics Quiz
### What is a debt security?
- [ ] An equity instrument representing shares in a company.
- [ ] A physical certificate of deposit.
- [x] A financial instrument representing money borrowed that must be repaid.
- [ ] A derivative financial asset.
> **Explanation:** A debt security represents money borrowed by an issuer that must be repaid, typically with interest, at a specified maturity date.
### Which of the following is an example of a debt security?
- [ ] Common stock
- [ ] Preferred shares
- [x] Bonds
- [ ] Stock options
> **Explanation:** Bonds are a type of debt security, where an investor lends money to a corporation or government in return for periodic interest payments and repayment of principal at maturity.
### What differentiates a note from a bond?
- [ ] Creditworthiness of the issuer
- [ ] Interest rate structure
- [x] Length of maturity
- [ ] Issuer's location
> **Explanation:** Notes generally have intermediate maturities (between one and ten years), while bonds typically have longer maturities (more than ten years).
### How does a discount affect a debt security?
- [ ] It reduces the interest payments.
- [ ] It increases the interest rate.
- [x] It lowers the initial purchase price below face value.
- [ ] It extends the maturity date.
> **Explanation:** A discount occurs when the debt security is sold at a price below its face value, offering implicit interest to the holder over the life of the security.
### What is the primary risk associated with debt securities?
- [ ] Market risk
- [ ] Liquidity risk
- [x] Credit risk
- [ ] Operational risk
> **Explanation:** Credit risk is the main concern, as it pertains to the possibility that the issuer may default on interest payments or fail to repay the principal.
### Who might issue commercial paper?
- [ ] Individual homeowners
- [ ] Governmental treasuries
- [x] Corporations
- [ ] Municipalities
> **Explanation:** Commercial paper is typically issued by corporations to meet short-term financing needs and generally has maturities of up to 270 days.
### What is another term for the face value of a bond?
- [ ] Discount value
- [ ] Market value
- [x] Par value
- [ ] Yield value
> **Explanation:** The face value of a bond is also known as the par value, which is the amount the issuer agrees to pay back at maturity.
### What role does the yield play in a debt security?
- [ ] It determines the security's maturity date.
- [x] It represents the rate of return relative to the current market price.
- [ ] It adjusts the principal repayment.
- [ ] It fixes the interest payments.
> **Explanation:** Yield is the measure of earnings generated and realized on an investment, calculated as the interest or dividends received from a security, adjusted to the current market price.
### Which debt security typically has the shortest maturity?
- [ ] Bonds
- [x] Bills
- [ ] Notes
- [ ] Preferred shares
> **Explanation:** Bills, like Treasury bills, have the shortest maturity, usually one year or less.
### What does 'liquidity' mean in terms of debt securities?
- [x] The ease with which the security can be bought or sold in the market.
- [ ] The amount of interest earned annually.
- [ ] The default risk of the issuer.
- [ ] The fixed interest rate agreed upon at issuance.
> **Explanation:** Liquidity refers to how quickly and easily a debt security can be converted into cash without significantly affecting its price.
Thank you for studying our detailed breakdown of debt securities and taking our challenging quiz. Continue to expand your expertise in finance!
