Debt Securities

Definition

Debt securities are financial instruments that represent a loan made by an investor to a borrower, typically corporate or governmental. They come with a promise to pay back the principal along with interest at specified intervals. Debt securities are crucial in investment activities, as they provide a way for investors to earn returns while also allowing organizations to raise capital for various purposes.

5 Must Know Facts For Your Next Test

1. Debt securities can be classified into different categories based on their risk level, issuer type, and other factors, including government bonds, municipal bonds, and corporate bonds.
2. The market for debt securities is generally less volatile than equity markets, making them a popular choice for risk-averse investors seeking stable returns.
3. Debt securities are recorded on the balance sheet at their amortized cost unless they are classified as trading or available-for-sale securities, which have different accounting treatments.
4. The interest income generated from debt securities can be taxable or tax-exempt depending on the type of security and the investor's tax situation.
5. Investors need to assess credit ratings assigned by agencies like Moody's or Standard & Poor's to evaluate the likelihood of receiving interest and principal payments on debt securities.

Review Questions

• How do debt securities play a role in investing activities and what advantages do they provide to investors?
  • Debt securities are key components of investing activities because they allow investors to lend money to issuers in exchange for periodic interest payments and eventual repayment of principal. They are generally seen as less risky than stocks and can provide a steady income stream through interest payments. Additionally, these securities can help diversify an investment portfolio by adding fixed-income elements, reducing overall volatility.
• Discuss the differences between available-for-sale and trading securities in relation to debt securities.
  • Available-for-sale (AFS) securities are debt securities that can be sold in the future but are not actively traded. These are reported at fair value on the balance sheet with unrealized gains or losses reported in other comprehensive income. In contrast, trading securities are also reported at fair value but with unrealized gains or losses included in earnings. This difference affects how changes in market conditions impact financial statements and investment strategies.
• Evaluate the potential impact of interest rate changes on debt securities and how this relates to investor decision-making.
  • Interest rate changes can significantly impact the value of debt securities. When rates rise, existing bonds typically decrease in value since newer issues come with higher yields. This creates interest rate risk for investors holding existing bonds. Consequently, when making investment decisions, investors must consider their exposure to potential interest rate movements and may choose to adjust their portfolios accordingly, either by diversifying into different types of debt securities or by shifting towards equities if they anticipate rising rates.

Related terms

Bonds:

Bonds are a specific type of debt security, usually issued by corporations or governments, where the issuer is obligated to pay periodic interest and repay the face value upon maturity.

Yield:

Yield is the income return on an investment, typically expressed as an annual percentage rate based on the investment's cost, current market value, or face value.

Interest Rate Risk: Interest rate risk is the potential for investment losses due to fluctuations in interest rates, which can affect the market value of debt securities.