The most common forms of debt securities are government and corporate bonds, as well as certificates of deposit issued by banks. A debenture is another term you may have heard. This is a corporate bond that is secured by property.
Like equity securities, debt securities can be bought and sold. For example, Australian government bonds and some corporate bonds are available via the ASX. For some corporate bonds, investors can deal directly with the companies offering them, and you can obviously deal directly with banks in making deposits.
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However, debt securities are a more secure investment than equity securities because there is a fundamental difference between the two. When an investor buys a government or corporate bond or makes a deposit with a bank, they are essentially loaning a government, corporation or bank their money. They have the right to be repaid the principal and the nominated interest rate. Government bonds in particular are extremely low-risk investments.
On the other hand, with equity securities like shares, they are an investment in a company, rather than a loan. That investment can go one of two ways. If the company is profitable, the investor is likely to make money through an increase in the share price and dividend payments. However, if the company struggles, the share price and dividend payments will decrease. With equity securities, there is therefore more risk that investors can lose their money. Debt securities are far more secure and even if a company goes bankrupt, debt securities have priority for repayment.
Short-term debt securities are those that have less than 12 months to their maturity date. Even for terms less than 12 months, bonds or term deposits will usually provide a higher rate of interest for investors than everyday savings accounts. Short-term debt securities also provide investors with a regular return, without tying their money up for long periods.
Long-term debt securities are for periods longer than 12 months. These securities may offer higher rates of return to entice investors to tie their money up for longer periods. The advertised returns on long-term debt securities can also be an indicator of where the market will head in future (e.g. if they offer returns that are increasing or decreasing over longer time periods).
Investing in long-term debt securities with fixed rates of return allows investors to lock in these rates so that they won’t be affected if market rates subsequently fall. However, the opposite is also true. Long-term debt security investors will be disadvantaged if they have locked in a fixed return and market rates subsequently increase. Depending on the bond, the investor may be able to sell prior to their maturity date, but they will likely be charged additional fees which may not make that decision worthwhile. In addition, investors who need to sell any debt security prior to its maturity date will also likely receive less than the security’s face value. They may also be difficult to sell, making them a less liquid form of investment than equity securities like shares.
A yield curve is a graphical illustration of bond interest rates. It compares bonds with relatively equal risk over different short and long-term maturity dates (e.g. quarterly, 1 year, 2 year, 5 year, 10 year etc.). Yield curves are therefore a reflection of the level of future returns currently on offer in the market. They can also influence other loan interest rates in the market and are often used to predict future economic activity.
The shape of the yield curve indicates potential future interest rate movement. If the yield curve is upward sloping, this is an indication that bond rates and economic activity are expected to rise over time. If it is downward sloping, this indicates the opposite (i.e. that bond rates and economic activity are expected to decrease over time).
The yields of debt securities are influenced by several factors. The main ones are:
- Interest rates. Market interest rates offered on the different debt securities available in the market exert influence on each other. For example, banks have to offer competitive interest to attract deposits and corporations need to offer attractive bond rates to entice investors.
- The inflation rate. Inflation erodes the purchasing power of money over time. During periods of high inflation, the rates of return on long-term debt securities especially will need to be attractive to compensate investors.
- General economic conditions. Economic growth and the level of business activity is significantly influenced by current economic conditions. For example, if consumer and business confidence is low, economic growth may stagnate, potentially increasing unemployment. This may lead the Reserve Bank to cut interest rates to stimulate the economy, which will also influence debt security rates. Conversely if the Reserve Bank raised interest rates to try and curb inflation, this would place pressure on debt security rates to also rise accordingly.
- Debt securities are comparatively low risk compared to other forms of investment, and their returns are often lower accordingly. However, corporate bonds are higher risks than government bonds or bank deposits, so their rates may be comparatively higher to reflect this increased risk.
Adviser’s Tip: Debt securities are more secure than equity securities and help to diversify and balance the overall risk in your investment portfolio.
Further Reading: www.asx.com.au/education, The Intelligent Investor by Ben Graham, One up on Wall Street by Peter Lynch.