Debt securities

It is possible to name the following advantages of debt securities:
• it is an attractive alternative to bank deposits;
• there is an opportunity to sell them to maturity;
• when sale the accrued interest are preserved (not lost), and penalties are not charged;
• unlike other investment products, there is a wide choice of different combinations – yield/ currency / risk / term investments;
• the opportunity to purchase securities of various companies from different sectors of the economy, working in different countries.
It is also possible to point benefits of investing in debt securities.
1. The first benefit is stable and predictable interest payments
2. Flexibility and Convenience
For more detailed characteristics of debt securities as investment vehicles we will consider bonds of corporation.

Corporate bonds
Bond is a debt security certifying the payment of its owner, and supporting obligations of the issuer to reimburse the value of the securities to the investor at a certain date, with payment of the fixed percent of the nominal value of the bond. According to the definition, Corporate bonds are debt securities issued by private and public corporation, for example, private companies and their subsidiaries may issue corporate bonds. (Wilson, 1995)
When buying a corporate bond, investors are lending money to the corporation, which in its turn promises to return the principal on a specified maturity date to the bondholders, and before that maturity date the corporation periodically pays defined interest rate.
Fundamental properties of bonds are:
1. Loan relationships between the investor and the issuer. The person, acquiring a bond, does not become a part owner of the enterprise, but is the lender;
2. The presence of the maturity date of the bonds, after which it is redeemed by the issuer at its nominal value.
3. The priority of the bonds compared with the shares in income. It means that payment of interest on the bonds is a priority over the payment of dividends.
4. The right of the bonds owner to satisfy his demands is a priority over shareholders in case of liquidation of the enterprise. (Wilson, 1995)
Most companies issues bonds in order to get extra capital. Unlike bank loans, bond issues provide the possibility to get credit resources for longer periods, as in most cases bonds maturity is about 10 ~ 15 years. And it is necessary to note that, by issuing bonds, the firm does not increase its share capital, as investors who have acquired the bonds, are not shareholders and therefore do not participate in enterprise management.
Further consideration should be given to such an important issue as the price of bonds, and how does price influence return for investors.
In general, the current price of bonds can be represented as the value of expected cash flows to the current point in time. Cash flow consists of two components: the coupon payments and face value of bonds payable at its maturity. Thus, the bond price is the present value of annuity and its nominal value. (Wilson, 1995)
In determining the price of a bond must be provided the following conditions:
– the cash flow is shown in the context of the period, stipulated for payment of the coupon income, which varies in accordance with the terms of the bond issue;
– the market rate of return is established taking into account the risk of these investments, and profitability, emerging in the alternative sector. The required rate of return may vary at different periods of the functioning of the bonds;
– the period of the bonds has a maturity, after which they must be redeemed. (Wilson, 1995)
The next important question is the factors that affect the price of bonds. On the stock market bonds are sold at prices that differ from their nominal value in one direction or another. The price of bonds is affected by many factors: the level of interest rates, period of bonds, maturity, issuer rating, and others. (Ganquin et al., 2004)
First of all, the bond price depends largely on its rate of income, which is defined by the nominal value of bond and the existing (expected) rate of return in financial markets. If we assume that the investor has alternative investment funds, in all other things being equal, he prefers the alternative that has the greatest yield. In this case, if the coupon is 12% per annum and alternative investments provide the same yield, then, consequently, the bond should be sold at its nominal value. And if the yield on bonds is 8%, and investor expected returns on other investments are 12%, then the bond price should fall below its nominal value. In this case the bond is sold at a discount, and discount provides the same yield as if investing in alternative areas. (Ganquin et al., 2004)
It is important to mention the process and conditions for redemption of bonds. Issuing bonds with fixed interest for a long period of time, the issuer bears interest rate risk associated with interest rate fall in the future. In order to insure against losses, while paying a fixed coupon in the fall of interest rates, companies can use early redemption of their bonds. Callable or redeemable bonds are bonds that can be redeemed or paid off by the issuer prior to the bonds’ maturity date. In order to carry out such operations in the bond issue must be authorized their callability. The price of callable bonds typically consists of three elements: the bond’s nominal value, coupon yield and the premium for long-term possibility of redemption. (Ganquin, 2004)
When an issuer calls its bonds, it pays investors the calls price (usually the face value of the bonds) and accrued interest to date. This gives the issuing company a clear advantages in response to changes in interest rates: if interest rates fall, the company exercises its right to redemption to avoid paying too high interest rates. Also, instead of callable securities the company can issue new bonds with lower coupon rate, to reduce the cost of debt servicing.
According to the U.S. Securities and exchange commission, callable bonds are more risky for investors than non-callable bonds. This can be explained by the fact that an investor in that case is faced with reinvesting the money at a lower, less attractive rate. That is why callable bonds often have a higher annual return, to compensate for the risk that the bonds might be called early. (U.S. Securities and Exchange Commission)
It is important to note that in case of bond redemption the investor does not receive the entire amount of income, which he expected to receive when the bonds were purchased. To protect the interests of investors in the terms of issue is usually specified the period within which a company can not redeem the bonds. Typically, this period shall be within 5-10 years. During this period, the investor is protected from the early withdrawal of bonds and has a guaranteed coupon yield, established in the issuance of bonds in circulation.
The next important question to consider is the investment quality of bonds. When purchasing corporate bonds, the investor should evaluate their investment quality, and weigh the risks and returns of those securities. Evaluation of investment qualities of bonds is made in the following areas:
– First, it is necessary to determine the reliability of the company and its ability to make the interest payments. For this purpose are usually compared the income, earned by the company during the year, with the sum of interest payments on all types of loans.
– Second, it is necessary to estimate the company’s ability to repay existing indebtedness. An investor should consider that, except for bonded debt, the firm may have other debt obligations. Therefore, the analysis compares the revenue of the company with its total debt, and acceptable level of the ratio of the amount of income to the value of debt is not less than 30%.
– Third, the estimated financial independence of the company.
At last it is necessary to mention the FASB accounting requirements for debt securities, which are listed in the Statement No. 115. This Statement includes the accounting and reporting for such debt securities:
– held-to-maturity securities , which are debt securities that the enterprise holds to maturity. They must be reported at amortized cost.
– trading securities , which are debt and equity securities that are bought and held for the purpose of selling them in the near term. They must be reported at fair value, with unrealized gains and losses included in earnings.
– available-for-sale securities, which are debt and equity securities not classified to either categories. They must be reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders’ equity. (FASB, 2011)