During a bull market, investors flock to equity securities to try to earn the highest possible returns. But, the risk inherent in equity securities remains. To reduce risk and achieve diversification, an investment portfolio needs to contain a variety of types of securities. Debt securities add some much-needed diversification to a balanced portfolio. They also have risk, but on the risk-return continuum, they are generally less risky than equity and add a return-of-capital feature to your portfolio. There is a wide range of debt securities available. They can differ in form, structure and features. Here’s what you need to know.
If you want to add debt securities to your portfolio, you may want to contact a financial planner.
What Is a Debt Security?
A debt security is one type of financial asset that represents money that one party owes to another party. For example, a government entity or a corporation may issue debt securities to raise money for their operations. Investors buy the debt security and provide that money. In return, they receive interest on their money and repayment of the principal at maturity.
Debt securities are called fixed-income securities since they generate a fixed amount of interest each year. If they are held to maturity, they also return the initial principal to the investor. Debt securities are not without risk. During the lifetime of debt securities, the risk occurs because the company might go bankrupt or default on its obligations. In the event of bankruptcy, bondholders get paid before stockholders.
Why Invest in Debt Securities
The return of capital to the investor at maturity is one attractive feature of debt securities. Equity securities, or stock, do not promise that. Another attractive feature is the current income in the form of interest payments. You can structure a portfolio of debt securities to meet your income needs by staggering the maturities of the securities as you wish. Debt securities provide a measure of liquidity to your portfolio. You can buy and sell them at any time since government and most corporate debt securities are liquid and can be quickly and easily sold.
Consider the tax implications of investing in debt securities. The interest payments you received are taxed as ordinary income. The capital gains you may receive when you sell the debt security, either at maturity or before, are taxed at the lower capital gains rate.
If you are a risk-averse investor, you can increase your returns by investing in debt securities over what you would earn on a financial asset through your bank. You can also diversify your investment portfolio by including different types of financial assets. Debt securities, like bonds, are financial assets that represent the money you have loaned to a corporation or government. Equity securities, like stock, represent claims on the earnings of the firm, but there is no guarantee you will ever receive a return on your investment.
As an investor, unless you need your interest payments from debt securities for current income, you might consider buying debt securities for your retirement portfolio since it is tax-advantaged.
What Drives Bond Prices
Bonds are one of the most common debt securities. They are issued by governments and corporations to investors to raise money for operations. Three factors typically drive bond prices:
- Interest Rates – The stated interest rate on a bond is called the coupon rate. When interest rates rise, bond values fall. When interest rates fall, bond values rise. Let’s say that a corporate bond is issued with a coupon rate of 4%, but the going rate in the broad economy is 2%. Interest rates have fallen since the bond was issued. This makes the 4% bond attractive to investors because of the higher interest rate. Conversely, if the interest rate on your bond is 2% and interest rates generally are 4%, that bond is not attractive to investors because it has a lower interest rate.
- Inflation – When inflation goes up, bond values fall and vice versa. This is because inflation erodes the purchasing power of your investment returns. If there is inflation when you have a maturing bond, your returns on that bond will buy less in today’s dollars.
- Credit Ratings – When a bond is issued, it is assigned a credit rating just like an individual is assigned a credit score. The credit rating is an indication of how likely repayment of the principal is to the investor at maturity. The three major U.S. credit rating agencies are Standard and Poor’s, Moody’s and Fitch. They take the strength of the issuer’s balance sheet and the condition of its operations into account. They also take macroeconomic factors into account. Those factors are the future economic outlook for the issuer, current business conditions and the strength of their government’s economies. The lower the credit rating, the riskier the bonds from the issuer and, thus, the lower the price.
Types of Debt Securities
There are several different types of debt securities that you can consider for your portfolio. Consider these:
- U.S. Treasury Bills, Notes and Bonds – These government debt securities have little risk since they are backed by the full faith and credit of the U.S. government. Because of their very low risk, they have a low rate of return. They tend to be most popular for conservative, risk-averse investors. Treasury bills have very low interest rates and maturities ranging from a few days to one year. Treasury notes have longer maturities up to 10 years. Both Treasury bills and notes can be bought at a discount. Treasury bonds and Treasury Inflation-Protected Securities (TIPS) have longer maturities. TIPS are the same as Treasury bonds except the principal changes to keep up with inflation.
- Corporate Bonds – A corporate bond is a contractual obligation between a company and an investor. The investor loans the company the face value of the bond. In return, the company agrees to pay the investor a fixed interest payment every year plus repay the principal at maturity. There are many grades of corporate bonds across a spectrum ranging from investment grade to sub-par bonds. These grades are assigned depending on the credit risk of the issuing company. If you invest in riskier bonds based on their creditworthiness, you can potentially earn a higher return. However, the risk of default also increases. One thing to watch for as an investor in corporate bonds is whether or not the bond has a call feature. In other words, is the company able to call in its bonds and repay them before maturity?
- Municipal Bonds – Municipal bonds are issued by state and local governments to raise money for particular projects. The interest from municipal bonds is exempt from federal taxes. However, if you sell a municipal bond and earn capital gains, they are subject to taxes. Municipal bonds are usually also exempt from state and local taxes if you live in the state of the issuer. The interest rate, or coupon rate, on the bonds is lower than that on corporate bonds since the interest is exempt from federal taxes.
- Bond Mutual Funds and ETFs – Bond mutual funds or exchange-traded funds (ETFs) are a way to start investing in debt securities. Bond mutual funds have a variety of investment goals and you can choose a fund that matches your goals. Bond ETFs trade in the stock market and may have a lower expense ratio than mutual funds.
- Foreign bonds – It is possible to diversify your portfolio in a different way if you invest in foreign bonds or bonds issued by companies outside your home country or foreign governments. The risk of default may be higher than on U.S. bonds. If the bond is denominated in a currency other than the investor’s home currency, that increases the risk.
- Commercial Paper – Commercial paper is a low risk debt security that is popular with institutional investors. It is a short-term financing method for companies that need short-term cash for their financing needs. If you invest in commercial paper, you don’t receive interest payments, but you do receive the difference between the face value and its value at maturity. Commercial paper requires a large initial investment.
- Hybrid Securities – Hybrid securities have some of the characteristics of both debt and equity. An example is a convertible bond. Convertible bonds pay a fixed interest payment, but they offer the opportunity to convert into shares of the issuing company’s stock at a later date.
In addition to these seven major categories of debt securities, new types of debt securities have been developed, some quite controversial.
- Collateralized Debt Obligations (CDO) – This is a new debt security product that is mostly used by institutional investors. CDOs are bonds built on top of bonds. A CDO is a debt security backed by other debt securities which compounds its risk.
- Mortgage-Backed Securities (MBS) – These securities are debt securities backed by a portfolio of mortgages. The mortgages are usually grouped together by interest rate. If you buy an MBS, you will receive principal and interest payments.
- Collateralized Mortgage Obligations (CMO) – This type of debt security is backed by pools of mortgages and is similar to the CDO. It is also called a real estate mortgage investment conduit (REMIC).
- Junk Bonds – Junk bonds are corporate bonds issued by corporations with low credit ratings. Investors use them if they want the potential for higher returns, but the risk of junk bonds is higher than the risk of investment-grade corporate bonds.
The Bottom Line
Debt securities are a major class of financial assets that investors can consider if they are risk-averse or if they want diversification in their portfolios. There are many types of debt securities with varied characteristics. You can diversify by choosing different types of securities, different grades of creditworthiness and different terms. It depends on your time horizon, investment goals and risk preferences. Consider holding your debt securities in a tax-advantaged retirement portfolio so you can defer paying taxes until you are retired and probably in a lower tax bracket.
Tips for Investing
- If you think you might want to invest in debt securities, it might be best to talk with a financial advisor. Finding one doesn’t have to be hard. If you use SmartAsset’s financial advisor matching tool, you can find a financial advisor to your liking. If you’re ready, get started now.
- If your investments pay off, you may owe the capital gains tax. Figure out how much you’ll pay when you sell your stocks with our capital gains tax calculator.
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