Debt Security

What Is a Debt Security?

A debt security is a financial instrument that represents a loan. When you buy one, you become a lender to the issuer, which may be a national government, a municipality, or a company. In return, the issuer agrees to pay interest at set intervals and to repay the original amount borrowed on a specified date. Well-known examples include bonds, notes, and debentures, along with short-term instruments such as commercial paper.

How Debt Securities Work

Each debt security has a few defining features. Its face value, or par value, is the amount the issuer repays at maturity, the date when the obligation ends. The coupon is the interest paid to the holder, often as a fixed share of face value, though some securities pay variable rates or no periodic interest at all. Some short-term securities are sold at a discount to face value instead, and the holder's return comes from the difference.

Debt securities usually trade in secondary markets after they are issued, so their prices move over time. When market interest rates rise, existing securities paying lower rates generally become less attractive and their prices tend to fall, and the reverse is also generally true. This sensitivity is known as interest rate risk. A price can also drop if investors doubt the issuer can keep its promises, a concern tied to credit risk.

Why Debt Securities Matter

For many investors, debt securities are a way to seek income that is more contractual than stock dividends, since the payment terms are set in advance. Holders of debt are creditors rather than owners. If an issuer goes bankrupt, they generally have a higher claim on remaining assets than holders of equity. That priority does not guarantee repayment. Debt securities are also widely used to diversify a portfolio, because their prices often respond differently from stock prices, though that relationship is not constant.