As the Canadian entrepreneur found out, debt securities are an alternative to bank loans for raising capital and financing growth. But debt securities generally have more features than bank loans and must be understood before they are used. Both issuers and investors need to fully understand the key features and risks of financing with debt securities. The financial consequences of not doing so can be substantial.

The following points recap what you have learned in this chapter about debt securities:

■ Debt security or bond issuers are typically companies and governments.

■ A typical debt security is characterised by three features: par value, coupon rate, and maturity date.

■ Coupon and principal payments must be made on scheduled dates. If the issuer fails to make the promised payments, it is in default and bondholders may be able to take legal action to attempt to recover their investment.

■ Debt securities are classified as either secured debt securities (secured by collateral) or unsecured debt securities (not secured by collateral). Debtholders have a higher priority claim than equityholders if a company liquidates, but priority of claims or seniority ranking can vary among debtholders.

■ Bonds may pay fixed-rate, floating-rate, or zero coupon payments.

■ Fixed-rate bonds are the most common bonds. They offer fixed coupon payments based on an interest (or coupon) rate that does not change over time. These coupon payments are typically paid semiannually.

■ Floating-rate bonds typically offer coupon payments based on a reference rate that changes over time plus a fixed spread; the reference interest rate is reset on each coupon payment date to reflect current market rates.

■ The only cash flow offered by a zero-coupon bond is a single payment equal to the bond’s par value to be paid on the bond’s maturity date.

■ Many bonds come with embedded provisions that provide the issuer or the bondholder with particular rights, such as to call, put, or convert the bond.

■ Securitisation is a process that creates new debt securities backed by a pool of other debt securities. These new debt securities are called asset-backed securities. Most asset-backed securities generate monthly payments that include both interest and principal components.

■ A bond’s current yield is calculated as the annual coupon payments divided by the current market price. It provides an estimate of return from coupon income only.

■ The value of a typical debt security is usually estimated by using a discounted cash flow approach, which estimates the value of a debt security as the present value of all future cash flows (interest and principal payments) that are expected from the debt security. The discount rate used to estimate present value represents the required rate of return on the debt security based on market conditions and riskiness.

The discount rate that equates the present value of a bond’s promised cash flows to its market price is called the yield to maturity, or yield. Investors use a bond’s yield to approximate the annualised return from buying the bond at the current market price and holding the bond until maturity.

■ The term structure of interest rates depicts the relationship between government bond yields and maturities and is often presented in graphical form as the yield curve.

■ The primary risks of investing in debt securities are credit or default risk, interest rate risk, inflation risk, liquidity risk, reinvestment risk, and call risk.

■ The credit spread is the difference in the yields of two bonds with the same maturity but different credit quality. Investors commonly assess the credit spread of risky corporate bonds relative to government bonds, such as US Treasury bonds.