Disadvantages of Debt Securities

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Debt securities are types of investment instruments that companies use in order to raise capital. The most common type of debt security is the bond, which is issued by the company and sold to investors, who hold the bond like a loan with an interest rate and maturity date. Other types of debt securities include preferred stock (as opposed to common stock) and certificates of deposit, or CDs. This type of investment has advantages both for organizations and investors, but it also creates issues that investors should be wary of.

Liquidity

  • Liquidity is a measurement of how easily an investment can be turned into fluid value. The most fluid instrument is cash itself, but securities have a range of different liquidity ratings. Securities like bonds and CDs have some of the lowest liquidity ratings. They are very difficult to turn into cash, essentially sealing money away for a period of time unless other investors are willing to buy these debts, and there is not as strong a market for debt securities as for other investments, such as shares.

Interest Rate Dependence

  • A debt security depends primarily on its interest rate for investor profit. If demand for a particular bond is very high because of falling bond rates, an investor may be able to make a greater profit buy selling the bond outright, but this is typically more difficult to do than with other investments. Shares, for instance, can increase rapidly on market value and do not depend on interest rates to create profit. Debt securities tend to be safer, but investors can also miss opportunities.

Business Debt Obligations

  • When a business creates a debt security like a bond, it is essentially creating a debt for itself. This debt is due in the future, so the company can use the funds now while delaying the debt. But when the debt comes due, the company must pay both the principal and the interest. This means the business must save and plan to finance these bonds when payment is due. If a large series of bonds comes due when the company is not prepare, the business may struggle to pay the debt and other operations can struggle.

Debt vs. Equity

  • From an industry perspective, businesses have an ideal balance of debt and equity, or financing through debt securities and finance through stock. Too much reliance on debt securities sold to investors will unbalance this ratio and raise suspicions of the business's solvency. Investors are not as willing to invest in a company that depends too much on debt.

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