Types of Debt Securities

Debt securities are debt instruments of corporations, governments, governmental agencies, or other organizations. Each one is essentially a sophisticated form of IOU: organizations issue debt securities to raise capital, promising interest income in exchange for the use of this money. Most debt securities pay interest at a fixed rate until the maturity date, when the principal is returned, and for that reason are sometimes called fixed income securities. Common types of debt securities include corporate bonds, municipal bonds, and treasury bonds.

Corporate bonds are debt securities issued by corporations. Interest is generally paid semi-annually. The investor receives the face amount of the bond at the bond’s maturity date. Interest rates depend on the creditworthiness of the issuing company and the duration of the bond. The bond’s duration is the length of time until the maturity date. Longer duration bonds pay higher rates of interest, as the investor is assuming greater risk. Some corporate bonds have a call feature, where the corporation has the right to repurchase the bond at a specific date prior to the bond’s maturity.

Municipal bonds are issued by states or municipalities to fund projects or borrow money to meet general obligations. Municipal bond interest is exempt from federal income taxes. Most municipal bond interest is exempt from state and local taxes for taxpayers of the state in which they are issued. Capital gain from the sale of municipal bonds is taxable income on both the federal and state levels. Interest rates are lower than corporate bonds. Municipal bonds may be revenue bonds, where revenue from a specific project, such as an airport terminal, is dedicated to making interest payments on the bond.

The U.S. Treasury issues Treasury bills, Treasury notes, and Treasury bonds. Treasury bills have durations of less than one year; Treasury notes have durations between one and ten years; Treasury bonds have durations over ten years. Treasury debt is considered amongst the safest debt in the world, because it's backed by the U.S. governments's full debt-paying capacity. Correspondingly, interest rates for these federal instruments tend to be lower than interest rates of other debt securities.

Series EE savings bonds are another form of debt security. Series EE bonds accrue interest quarterly; interest is paid when the bond is redeemed. Some investors can receive tax benefits when using Series EE bonds for education funding. Series 1 bonds, a second class of savings bonds, are very similar but are adjusted for inflation rather than offering a fixed rate throughout their lifetime.

Some debt securities are pools of individual debts. Examples are collateralized mortgage obligations and collateralized debt obligations. These pools of debt securities are packaged together and sold to investors as a single debt security.

Large, financially secure corporations finance their short term obligations by selling "commercial paper," a short-term promissory note. It's sold at a discount and then matures to face value, providing the buyer with a return. Commercial paper is sold in units of $100,000 or more, so it's primarily purchased by institutional investors such as mutual funds rather than individual investors.