A debt security is a financial instrument in which an investor (creditor) lends money to an issuer (borrower) in exchange for a contractual promise to pay periodic interest (coupon) and return principal (par/face value) at maturity. The terms are specified in an indenture or similar legal document. Debt securities include bonds, notes, bills, debentures, commercial paper, and certificates of deposit.
Debt holders are creditors, not owners. In the capital structure, they rank senior to all equity holders in claims on assets and income. Secured debt is backed by specific collateral; unsecured debt (debentures) relies on the issuer's general creditworthiness. This priority makes debt securities less risky than equity — but also limits their upside to the stated interest rate.
Key risks for debt security investors: interest rate risk (prices fall when rates rise — the dominant risk for investment-grade bonds), credit/default risk (issuer fails to make promised payments), reinvestment risk (coupon payments must be reinvested at unknown future rates), call risk (issuer retires debt early), inflation risk (fixed payments lose purchasing power), and liquidity risk (difficulty selling at fair price).
Duration quantifies interest rate sensitivity: a bond with a duration of 7 years will fall approximately 7% in price for each 1% rise in yields. Convexity measures the curvature of the price-yield relationship, providing a more accurate estimate of price changes for large rate moves.
> Exam tip: On the Series 7 and Series 65/66, master the inverse relationship between bond prices and yields. Know the priority of debt claims over equity in liquidation. Understand that duration, not maturity, is the correct measure of interest rate sensitivity. Zero-coupon bonds have the longest duration for a given maturity.