Debt securities – what are they?
These are financial instruments that represent the issuer’s obligation to repay the borrowed amount – with the amount set by the debtor. The debtor also determines the interest rate and repayment date. In other words, debt securities create debt in a form controlled by the debtor.
How do securities work? The issuer issues such a document and authorizes its purchase. When the transaction is completed, the issuer becomes the buyer’s debtor. The investor thus gains the right to income (interest) and the repayment of the nominal value of the debt security – which occurs at a pre-planned investment termination date.
The most popular examples of debt securities are:
- bills of exchange,
- treasury bonds,
- corporate bonds,
- trade notes,
- covered bonds.
A comprehensive discussion of each type of debt security can be found later in this text.
How do debt securities work?
Key concepts
Debt securities have their own distinctive elements, understanding which is crucial to understanding how these financial instruments actually work.
- Nominal value – this is the amount recorded on the security at the time of its issuance and, at the same time, the amount the issuer must pay the buyer at the end of the investment period. The value of a debt security can change over time, meaning the buyer is not required to purchase it at face value. Regardless of the actual amount paid, the issuer is obligated to pay an amount equal to the face value of the security.
- Issuer – the entity that issues (issues) debt securities. This role is most often played by the State Treasury, enterprises (companies), and financial institutions.
Important!
It’s worth remembering two types of issuances that exist on the market:
- Own issuance – this is a situation in which the issuer issues and sells the securities independently.
- Outsourced issuance – this is a situation in which the issuer uses the services of a financial institution to issue and sell debt securities.
- Maturity – this is the point at which the assumed investment period ends. Upon maturity, the issuer is obligated to return the face value of the debt security to the buyer.
- Interest – in the context of debt securities, this refers to regular payments made by the issuer to investors throughout the term of the security – in other words, it is a fee for borrowed funds.
- Option to resell on the secondary market – before maturity, the investor can resell the debt security on the secondary market. This allows them to recover all or part of their principal while simultaneously transferring the right to earn interest (and the face value) to a subsequent buyer.
Issuer’s obligations
Depending on the terms of a specific issue, the issuer’s obligations may vary in detail. However, three points remain unchanged, as they are regulated by law. The issuer is therefore obligated to:
- Redeem the issued debt securities at the end of the investment period.
- Pay investors the nominal value at maturity.
- Regularly pay interest arising from the issue.
How does the buyer of debt securities earn money?
An investor who purchases debt securities can earn money in two ways.
First, the issuer pays buyers interest over the entire investment period. This is the primary way to earn money from debt securities.
Second, the investor can resell their debt securities on the secondary market, as their value fluctuates over time.
Important!
The value of debt securities can fluctuate in any direction. Therefore, an investor who purchases financial instruments with the intention of cashing them out before maturity may find themselves unable to make a profit on their investment, or even experiencing a loss.
Issuance of debt securities step by step
Debt securities are issued in several stages.
- Step 1: Issue Parameters – In this stage, the issuer determines the type of debt securities it wishes to issue and the terms.
- Step 2: Prospectus – The planning stage concludes with the preparation of a prospectus – a document (set of documents) in which the issuer provides information regarding the issue and its financial situation. Preparing a prospectus is – in most cases – a legal obligation for every issuer, and the document must be approved by the Polish Financial Supervision Authority.
Important!
The content and form of the prospectus are regulated by European Commission Regulation (EC) No 809/2004 on the implementation of Directive 2003/71/EC of the European Parliament and of the Council.
Important!
Not every issue requires a prospectus. If the issuer is issuing debt securities through a private placement (to fewer than 150 people), it only needs to prepare an information memorandum.
- Step 3: Subscription – At this stage, investors can subscribe to purchase debt securities.
- Step 4: Allocation – In this step, the issuer (or the financial institution handling the issue) allocates the purchased debt securities to investors.
- Step 5: Entry to the secondary market – Debt securities issued and allocated to buyers can be resold. A significant limitation is that securities can only be traded on the secondary market until maturity.
Types and examples of debt securities
Previously, we only mentioned, and now we also discuss in detail, examples of debt securities present on the market.
What are bills of exchange?
A bill of exchange is a commitment by the issuer to pay a specific amount within a specified, often relatively short, period.
Bills of exchange are often used not as a means of raising capital, but as additional security when using other financing (e.g., loans or online factoring).
Bills of exchange are divided into:
- promissory (when the issuer commits to repayment within a specified period),
- drawn (when the bill of exchange contains a payment order, which will be settled by the drawee – an entity or third party – within a specified period).
How do Treasury bonds work?
Treasury bonds have a specific issuer – the State Treasury. The government issues bonds to finance public spending or reduce debt. Treasury bonds are considered one of the safest bonds – the government guarantees repayment within a specified timeframe.
What makes corporate bonds stand out?
In this case, only the issuer and purpose change, but the risk increases as well. The issuer of a corporate bond is a company. The purpose of the issue may be – as in the case of treasury bonds – to reduce debt, but it will often be to finance investments or refinance other liabilities.
Corporate bonds typically have higher interest rates than treasury bonds – this is, of course, due to the increased risk.
How do commercial and treasury bills work?
Treasury bills are debt securities that allow companies or the State Treasury to obtain short-term financing while avoiding bank loans. Short-term nature means that the bills are typically redeemed within 12 months of the issue date. There are two types of bills:
- commercial (trade) bills – issued by companies. Buyers of commercial bills typically earn money through a discount (purchase at a price below the face value).
- treasury bills – the issuer of treasury bills is the state. In the Polish market, the face value of treasury bills is PLN 10,000. They are most often issued for periods of up to 90 days or up to 12 months.
How do covered bonds work?
Covered bonds are an example of debt securities issued by mortgage banks. The regulations governing covered bonds in the Polish capital market can be found in the Act on Covered Bonds and Mortgage Banks.
There are two types of covered bonds:
- mortgage – their issue is based on, and secured by, receivables from loans secured by mortgages;
- public – their issue is based on and secured by receivables from loans granted to local government units and public sector entities, or loans guaranteed by the National Bank of Poland (NBP), the European Central Bank (ECB), governments or central banks of EU member states, the Organisation for Economic Co-operation and Development, and the State Treasury.
Investing in debt securities – advantages
Like any investment, debt securities can also provide buyers with specific benefits. The most important include:
- Fixed income – purchasing debt securities entitles you to interest (coupons) paid at regular intervals by the issuers.
- Potential profit – debt securities can also be traded on the market – buying and selling existing debt securities before maturity. Debt securities can be sold at a price higher than their face value, resulting in a profit for the buyer. Another way to earn money is to purchase bonds and promissory notes sold at a discount (i.e., at a price lower than their face value).
- Investment diversification – debt securities are one of many ways to invest. Considering investment risks, it’s a good idea to invest in various investments. Losses incurred on one investment are not very significant if the investor has a diversified investment portfolio.
- Financial liquidity – owning debt securities does not require investors to hold them until maturity. Thanks to the possibility of trading debt securities on the secondary market, their holders can take advantage of changes in the value of securities to sell them at a profit or to support their financial liquidity.
What about the safety of investing in debt securities?
While investing in debt securities carries risk, it is generally lower than investing in corporate shares. However, much depends on the type of securities chosen:
- Treasury bonds are among the safest investment methods because the government guarantees the funds.
- Corporate bonds offer higher interest rates but are associated with higher risk because the guarantor is a private company whose financial condition can change significantly over the duration of the investment.
- Promissory notes and bonds are short-term debt securities – generally carrying a low risk, although this risk depends on market conditions.
What are the risks of investing in debt securities?
Investing in debt securities can be safe, but it’s never completely risk-free. When deciding to purchase debt securities, you should remember that complications can arise – especially when it comes to long-term investments. What risks might you face when investing in debt securities?
- Credit risk – the issuer can always go bankrupt or become insolvent. Even purchasing government bonds doesn’t guarantee a guaranteed profit.
- Interest rate risk – interest rates can change over the duration of the investment. These, in turn, depend on many difficult-to-predict factors. The longer the investment period, the greater the risk of factors influencing interest rates. These changes can, of course, be beneficial, but they constitute a risk that should not be ignored.
- Inflation risk – when calculating potential investment returns, it is essential to take inflation into account. A decline in the value of money can result in a lower-than-expected real return on investment.
- Liquidity risk – one of the significant benefits of investing in debt securities is the ability to resell your securities on the secondary market. However, to approach this issue responsibly, it’s crucial to remember that the ability to resell your debt securities doesn’t mean you’ll be able to sell them—not even at a satisfactory price. If you purchase securities that depreciate during the investment period, reselling them can be very difficult and will almost certainly result in a loss.
How to limit the risk of investing in debt securities? Rating agencies
-Rating agencies, or firms specializing in investment advice, operate in the market. Their role is to assess the financial situation and creditworthiness of securities issuers.
While they are not infallible, rating agencies provide investors with valuable knowledge about investment risk, thus exerting a real influence on the capital market.
How to settle debt securities? Taxes and formalities
Gains from debt securities are subject to taxation. They are treated as capital gains, subject to the 19% Belka tax in Poland. This applies to:
- interest earned,
- gains from the sale of debt securities on the secondary market (the difference between the purchase price and the sale price is taxable),
- purchases of debt securities at a discount (the difference between the purchase price and the nominal value is taken into account).
- Taxation obligations apply to both the issuer and the investor. The issuer of the debt security is required to withhold tax at source and remit it to the relevant tax office. The investor, in turn, must include the interest and coupon gains when filing their annual tax return and pay tax on the capital gains earned.
Investing in debt securities and tax relief
Before investing in debt securities, check if you’re eligible for tax relief. Some foreign investments are eligible for relief, and in Poland, this also applies to investing in IKE and IKZE accounts – the latter, however, are individual retirement accounts and aren’t intended for typical investment purposes.
Summary
Investing in debt securities is an interesting avenue that offers many potential benefits for both issuers and buyers. Issuers gain access to capital and can avoid taking out bank loans. Debt securities also allow them to maintain financial control.
For investors, debt securities offer a chance for stable passive income (interest and coupons) as well as potential profit from reselling the securities above the purchase price. Purchasing debt securities positively impacts financial liquidity and helps diversify an investment portfolio, thereby reducing the risk of unsuccessful investments.
Frequently Asked Questions
What are debt securities?
These are financial instruments issued by the State Treasury, corporations, or financial institutions. Debt securities represent the issuer’s obligation to repay the borrowed amount. This is an attractive solution for issuers who obtain financing on their own terms (they determine the value of the debt security, the investment term, the interest rate, and the repayment date). It also benefits investors, who earn interest and resell the securities on the secondary market.
What are the most popular examples of debt securities?
The most commonly issued debt securities include:
- bills of exchange,
- treasury bonds,
- corporate bonds,
- commercial bills,
- treasury bills,
- covered bonds.
What is the face value of a debt security?
Face value is the underlying amount recorded on the security at the time of its issuance. Although the actual value of a debt security may fluctuate over the life of the investment, the issuer commits to paying the face value upon maturity.
How do buyers of debt securities earn money?
The investor gains the right to interest (coupons), which the issuer pays out at regular, predetermined intervals throughout the investment period. Furthermore, the buyer can trade their securities on the secondary market.
What does the debt securities issuance process look like?
The debt securities issuance process can be divided into five stages:
- Establishing the issue parameters (the issuer selects the type of securities it wishes to issue and specifies the terms).
- Preparing a prospectus or information memorandum (the issuer prepares a document containing detailed information about the issue and the issuer’s financial situation).
- Subscription (investors subscribe to purchase debt securities from the issuer).
- Allocation (the issuer allocates the purchased securities to investors).
- Entry into the secondary market (the allocated debt securities enter the market and can then be resold until maturity).
