A debt security is a loan you make to a government or a corporation, packaged as a financial instrument you can hold or sell to someone else. When you buy a bond, a Treasury note, or a certificate of deposit, the borrower is contractually obligated to pay you interest on a set schedule and return your principal on a specific date. That obligation is legally enforceable, and if the borrower goes bankrupt, you stand ahead of stockholders in the recovery line.
That basic structure is the same whether you’re lending to the U.S. Treasury for 30 years or to a corporation for 90 days. What changes across products is who’s borrowing, how long they need the money, how risky they are, and how the interest gets taxed. Understanding those variables is the difference between buying a bond and knowing what you actually own.
The Four Terms That Define Any Bond
Every debt security is built from the same four pieces. Get comfortable with these and the rest of the market makes sense.
Face value, also called par value, is the amount the borrower promises to repay at maturity. Most bonds are issued in $1,000 increments, and face value doesn’t change no matter what the bond’s market price does in the meantime.1Municipal Securities Rulemaking Board. Municipal Bond Basics
Coupon rate is the annual interest rate the borrower pays, stated as a percentage of face value. A bond with a $1,000 face and a 5% coupon pays $50 a year, usually in two $25 installments. That rate is locked in at issuance.
Maturity date is when the borrower must return the full face value. Maturities run from a few days on the shortest instruments to 30 years on long-term government bonds. Once principal is repaid, the security is extinguished and interest stops.
Yield is what you actually earn based on what you paid, which is often not face value. Buy a 5% coupon bond for less than $1,000 and your yield-to-maturity is higher than 5%, because you’re collecting the same $50 on a smaller investment. Pay more than $1,000 and your yield drops below 5%. Bonds trade in an open market at prices that shift constantly, so coupon and yield are rarely the same number.
The Main Types of Debt Securities
Debt instruments sort into categories by who’s doing the borrowing and for how long. Each type carries a different risk profile and, importantly, a different tax treatment.
U.S. Treasury Securities
Treasuries are issued by the federal government and backed by the full faith and credit of the United States. They come in three basic forms:
- Treasury Bills mature in one year or less. They don’t pay periodic interest; you buy them at a discount and receive full face value at maturity.
- Treasury Notes mature in two to ten years and pay interest every six months.
- Treasury Bonds are issued in 20-year and 30-year terms with semi-annual interest payments.2TreasuryDirect. Treasury Bonds
The Treasury also issues Treasury Inflation-Protected Securities (TIPS). The principal on a TIPS adjusts with changes in the Consumer Price Index, and interest is recalculated on that adjusted principal every six months. If inflation runs at 3% and your TIPS pays a 1.5% coupon, your real return stays positive because the principal itself grows with prices.3TreasuryDirect. TIPS/CPI Data
Treasury interest is taxable at the federal level but exempt from all state and local income taxes, which can meaningfully improve after-tax returns in a high-tax state.4Internal Revenue Service. Topic No. 403, Interest Received
Corporate Bonds
Corporations issue bonds to fund operations, expansions, and acquisitions. Quality varies enormously depending on the issuer’s financial health, and rating agencies like S&P Global and Moody’s assign letter grades to help investors gauge that risk.
Bonds rated BBB- or higher by S&P (Baa3 by Moody’s) are considered investment grade, meaning the issuer has a reasonably strong capacity to meet its obligations.5S&P Global. Understanding Credit Ratings Anything below that line is high-yield, sometimes called junk. High-yield bonds compensate for the added default risk by paying wider spreads above comparable Treasury yields.6Federal Reserve Bank of St. Louis. ICE BofA US Corporate Index Option-Adjusted Spread
Interest on corporate bonds is taxed as ordinary income at both the federal and state level.4Internal Revenue Service. Topic No. 403, Interest Received
Municipal Bonds
State and local governments issue municipal bonds to fund public projects like roads, schools, and water systems. The main draw is the tax treatment: interest on most municipal bonds is excluded from federal gross income.7Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds If you live in the state that issued the bond, the interest is often exempt from state and local taxes as well.1Municipal Securities Rulemaking Board. Municipal Bond Basics
Because of that tax advantage, municipal issuers can offer lower coupon rates than comparable corporate bonds and still deliver competitive after-tax returns. To compare a muni against a taxable bond, divide the muni yield by one minus your marginal tax rate. A 3.5% muni yield is equivalent to about 5.4% for someone in the 35% federal bracket. Credit quality varies by issuer, so munis deserve the same scrutiny you’d apply to a corporate bond.
Money Market Instruments
These are short-term debt securities maturing in one year or less, designed for liquidity rather than long-term income.
Commercial paper is short-term, unsecured debt issued by large corporations, typically to cover payroll or inventory. It’s usually sold at a discount rather than paying periodic interest. Because it’s unsecured, only financially strong companies can issue it at attractive rates.
Certificates of deposit are time deposits from banks. They pay a fixed rate for a set term, and early withdrawal usually triggers a penalty. CDs up to $250,000 per depositor per bank are insured by the FDIC, which makes them one of the lowest-risk options in the debt universe.
How to Buy Debt Securities
Unlike stocks, most bonds don’t trade on a centralized exchange. The secondary bond market operates over-the-counter, meaning buyers and sellers negotiate through broker-dealers. Hundreds of thousands of individual bonds exist, many trade infrequently, and a dealer often buys from one investor, holds the bond briefly, and sells to another at a markup. Pricing is less transparent than in the stock market, and the bid-ask spread can eat into returns on small trades.
TreasuryDirect
For U.S. Treasuries, the simplest route is TreasuryDirect, the government’s online portal. You can buy T-Bills, T-Notes, T-Bonds, and TIPS at auction with no commission or markup. The minimum purchase is $100.8TreasuryDirect. Buying a Treasury Marketable Security Securities are held electronically in your account.9TreasuryDirect. Investing Directly With the U.S. Treasury (FS Publication 009)
The tradeoff is flexibility. TreasuryDirect doesn’t support selling before maturity, so if you need to exit early you’d have to transfer the security to a brokerage account first. For Treasuries you plan to hold to maturity, TreasuryDirect is hard to beat on cost.
A Brokerage Account
A standard brokerage account lets you buy Treasuries, corporate bonds, and municipal bonds on the secondary market. Most brokerages require a minimum of two bonds (about $2,000 in face value), though this varies. You’ll pay a commission or markup in exchange for the ability to sell whenever you want.
Bond Funds Versus Individual Bonds
Many retail investors get bond exposure through mutual funds or ETFs rather than buying individual bonds. A bond fund pools money and holds dozens or hundreds of bonds, providing diversification for a small investment. Fund shares pay income monthly rather than semi-annually, and the manager handles reinvestment and credit monitoring.
The critical difference: a bond fund has no maturity date. An individual bond returns your principal on a known date. A fund’s share price fluctuates indefinitely, and if interest rates rise, the fund’s price drops and stays down until the underlying portfolio turns over. You can’t simply wait for maturity to get your money back. For predictable cash flow and a guaranteed return of principal on a set date, individual bonds have the edge. For diversification and professional management without building a six-figure portfolio yourself, funds are the practical choice.
The Risks That Actually Move Bond Prices
Debt securities are generally less volatile than stocks, but less volatile is not risk-free. Four risks do most of the damage.
Interest Rate Risk
Bond prices and interest rates move in opposite directions. When rates rise, new bonds pay better coupons, so your older, lower-coupon bond becomes less attractive. Its market price falls until its yield matches what new bonds are offering. Long-maturity bonds get hit hardest because there are more future payments being discounted at the new, higher rate. Holding to maturity still returns your full face value, but selling early in a rising-rate environment locks in a loss.
Credit Risk
Credit risk is the possibility that the borrower can’t pay. It ranges from negligible for Treasuries to very real for high-yield corporate bonds. Rating agencies quantify this risk, but ratings can lag reality. A downgrade doesn’t just signal trouble; it immediately pushes the bond’s price down because investors demand a wider spread to hold riskier debt.
The gap between a corporate bond’s yield and a Treasury of similar maturity is the credit spread, and that spread is the market’s real-time price on default risk. When economic conditions weaken, spreads widen across the board, even for investment-grade issuers.
Inflation Risk
A fixed coupon buys less each year if prices rise faster than the interest you’re earning. A 4% coupon looks fine until inflation reaches 5%. Your principal repayment at maturity also loses purchasing power over time. Long-term bonds are most exposed because inflation compounds. TIPS address this by tying principal to the Consumer Price Index, though TIPS carry lower coupons and can lose principal value during deflationary periods.3TreasuryDirect. TIPS/CPI Data
Call and Reinvestment Risk
Some bonds give the issuer the right to repay principal early, usually after a set protection period. Municipal bonds frequently include a call option exercisable ten years after issuance. Issuers call bonds when rates drop, because they can refinance more cheaply.
You lose two ways. First, you lose a bond that was paying above-market interest. Second, you get your principal back in exactly the environment where reinvesting it at a comparable yield is difficult. Reinvestment risk applies more broadly, too, whenever coupon payments arrive during falling-rate periods and can’t be redeployed at the same yield.
Tax Treatment
Tax rules differ meaningfully across debt securities, and getting them wrong can erase the advantage that made a particular bond attractive.
Interest on corporate bonds and CDs is taxed as ordinary income at both federal and state levels. Treasury interest is taxable federally but exempt from state and local income taxes.4Internal Revenue Service. Topic No. 403, Interest Received Municipal bond interest is generally excluded from federal gross income, with exceptions for certain private activity bonds and arbitrage bonds.7Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds Brokers report taxable interest of $10 or more on Form 1099-INT.
Zero-coupon bonds and other instruments sold below face value at issuance create what the IRS calls original issue discount, or OID. OID is treated as interest and must be included in income as it accrues each year, even though you receive no cash until maturity. That catches many investors off guard: tax is owed annually on income not yet received.10Internal Revenue Service. Publication 1212 – Guide to Original Issue Discount (OID)
Holding to maturity generally produces no capital gain or loss, since you receive the face value you expected. Selling before maturity is different. Any gain on a bond bought at a market discount is treated as ordinary income to the extent of the accrued discount, not as a capital gain. Gains above the accrued discount receive capital gains treatment, with the rate depending on your holding period.11Office of the Law Revision Counsel. 26 USC Subtitle A, Chapter 1, Subchapter P – Capital Gains and Losses
What Happens If the Issuer Defaults
Default is the scenario every bond investor worries about, and the process is more structured than most people expect.
Publicly offered corporate bond issues must appoint an independent trustee under the Trust Indenture Act. That trustee, usually a large bank, acts on behalf of all bondholders. Once a default occurs, the trustee must exercise its powers with the same care and skill a prudent person would use managing their own affairs.12Office of the Law Revision Counsel. 15 USC 77ooo – Duties and Responsibility of the Trustee
When a corporate issuer files for Chapter 11, the goal is reorganization rather than liquidation. The company files a plan classifying all claims and specifying how each class will be treated.13United States Courts. Chapter 11 – Bankruptcy Basics Bondholders whose claims are impaired vote on whether to accept the plan.
Recovery varies. Secured bondholders, whose bonds are backed by specific assets, typically recover more than unsecured bondholders. Unsecured bondholders often receive a mix of new debt, equity in the reorganized company, or cash at a fraction of the original face value. The process can take months or years, and the bond’s market price during bankruptcy usually trades at steep discounts.
Debt Securities Versus Equity
The difference between a debt security and a stock comes down to one question: are you a lender or an owner? A bondholder lends money and expects repayment on a schedule. A stockholder buys a piece of the company and hopes it grows in value.
Bondholders receive fixed interest regardless of company performance. Stockholders receive dividends only if the board declares them, and share value depends on earnings and market sentiment. In a good year, equity can far outperform debt. In a bad year, equity holders can lose everything while bondholders keep collecting interest as long as the company stays solvent.
In bankruptcy, that priority becomes concrete. Secured creditors are paid first, then unsecured creditors, then equity holders get whatever remains. Stockholders in a bankrupt company often receive nothing. That priority structure is the single biggest reason debt securities are considered lower risk than stocks.
Stockholders typically get voting rights. Bondholders get none. A bondholder’s protections come from the bond indenture, a legal contract that can restrict the issuer from taking on excessive additional debt, selling key assets, or making shareholder distributions that would jeopardize repayment. Those covenants act as guardrails on the issuer’s riskier impulses.