Section 2: Main Features of Debt Securities
- International Monetary Fund
- Published Date:
- November 2009
2.1 Section 2 provides definitions of securities and debt securities, sets out the criteria used to distinguish debt securities from other types of securities, and outlines the main features of debt securities. These can be used to determine whether specific securities found in securities markets are debt securities. Borderline cases are also examined.
Definitions of a security and a debt security
2.2 A security is a negotiable financial instrument.4 Negotiability refers to the fact that its legal ownership is readily capable of being transferred from one owner to another by delivery or endorsement. While any financial instrument can potentially be traded, a security is designed to be traded on an organised exchange or “over the counter”, although evidence of actual trading is not required. The over-the-counter market involves parties negotiating directly with one another, rather than on a public exchange (2008 SNA 11.33 and BPM6 5.15).
2.3 Securities include debt securities, equity securities and investment fund shares or units. A debt security is a negotiable financial instrument serving as evidence of a debt (2008 SNA 11.64). Loans, deposits, trade credits and insurance technical reserves are non-negotiable financial instruments.
2.4 Financial derivatives are not classified as securities even if they are negotiable financial instruments. No principal amount is advanced that has to be repaid and no investment income accrues (MFSM 176). Financial derivatives are linked to specific financial or non-financial assets or indices and specific financial risks can be traded in financial markets in their own right through them (BPM6 5.80).
Distinguishing debt securities from other types of securities
2.5 Various criteria are used to distinguish debt securities from other types of securities such as equity securities, and investment fund shares or units (see Table 2.1).
Equity securities, which are also called shares (both listed and unlisted), are securities acknowledging claims on the residual value of a corporation after the claims of all creditors have been met (2008 SNA 11.83).
Investment fund shares or units are issued by investment funds, which are collective investment undertakings through which investors pool funds for investment in financial and non-financial assets (2008 SNA 11.94).
|Debt securities||Equity securities||Investment fund shares|
|Main characteristics||Issuer is obliged to pay a specified amount of principal and interest to the owner||Acknowledgement of claims on the residual value of a corporation after the claims of all creditors have been met||Issued by collective investment undertakings and representing a share in an investment portfolio|
|Type of income||Interest||Dividends||Investment fund income|
2.6 The different types of securities can also be distinguished by type of income. While debt securities accrue interest, equity securities pay dividends, and investment fund shares or units pay investment fund income.
Main features of debt securities
2.7 Debt securities should display all, or most, of the following quantitative characteristics:
an issue date, on which the debt security is issued;
an issue price, at which investors buy the debt securities when first issued;
a redemption (or maturity) date, on which the final contractually scheduled repayment of the principal is due;5
a redemption price or face value,6 which is the amount to be paid by the issuer to the holder at maturity;
an original maturity, which is the period from the issue date until the final contractually scheduled payment;
a remaining (or residual) maturity, which is the period from the reference date until the final contractually scheduled payment;
the coupon rate that the issuer pays to the holders, which may be fixed throughout the life of the debt security or vary with inflation, interest rates or asset prices;7
the coupon dates, on which the issuer pays the coupon to the securities’ holders, and
the issue price, redemption price, and coupon rate may be denominated (or settled) in either domestic currency or foreign currencies.
2.8 Qualitative features of debt securities include:
the documents specifying the rights of debt securities issuers, in the form of indentures or covenants. The terms of contracts may be changed only with great difficulty, with amendments to the governing document generally requiring approval by a majority vote of the debt securities’ holders; and
the default risk attached to debt securities, which is the creditworthiness of individual debt securities issues assessed by credit rating agencies. For further details, see Section 6.
2.9 Debt securities may include loans that have become negotiable de facto, but only if there is evidence of secondary market trading, including the existence of market makers, and frequent quotations of the instrument, such as provided by bid-offer spreads (2008 SNA 11.65). These debt securities result from the conversion of loans, with the recording of two financial transactions, that is, liquidation of the loan and creation of the new debt security.
2.10 Debt securities also include private placements. Private placements of debt securities involve an issuer selling debt securities directly to a small number of investors. Typically, the creditworthiness of private placements are not assessed by credit rating agencies, and as the securities are generally not resold or re-priced, their secondary market is shallow. However, to the extent that some private placements can be (and are) traded among investors, the criterion of negotiability for debt securities is met.
Structured debt securities
2.11 Debt securities that combine different features of financial instruments pose challenges with respect to their classification. This is particularly the case for so-called structured debt securities, which are a sub-set of structured securities.
2.12 A structured debt security typically combines a debt security, or a basket of debt securities, with a financial derivative, or a basket of financial derivatives. This financial derivative, or the basket, is typically embedded in and therefore inseparable from the debt security. When the debt security and financial-derivative components of a financial instrument are separable from each other they should be classified accordingly, but if they cannot be separated then the instrument should be valued and classified according to its primary characteristics (BPM6 5.83 (d)), either as a debt security or financial derivative. For further details on structured debt securities, see Annex 1.
Islamic debt securities
2.13 Debt securities also encompass financial instruments governed by Islamic rules and principles (Sharī’ah). Islamic finance uses financial instruments that are backed by returns from a non-financial asset and earn a variable rate of return tied to the performance of the asset, or returns that are not specified before the investment is made, but shared on the basis of a pre-agreed ratio of actual earnings. Islamic debt securities are distinguished from equity securities by two categories of criteria. The first category comprises criteria used to differentiate conventional debt securities from equity securities. The second category comprises additional criteria used to distinguish Islamic debt securities from equity securities. These criteria and other details concerning Islamic debt securities are outlined in Annex 2.
2.14 Preferred shares8 typically rank higher than ordinary equity securities. They may carry superior voting rights to ordinary equity securities or no voting rights at all. They may entitle their holders to a dividend that is paid out prior to any dividends to ordinary equity holders and they may be convertible into ordinary equity securities. Only preferred shares that pay a fixed income and do not provide for participation in the distribution of the residual value of a corporation on its dissolution are classified as debt securities.
2.15 Depository receipts allow a non-resident institutional unit to introduce its debt or equity securities into another market in a form more readily acceptable to the investors in that market. A resident deposit-taking corporation will purchase the underlying securities and then issue receipts in a currency more acceptable to the investor. These instruments are classified according to the underlying financial instrument backing them, that is, as debt securities or equity securities. This is because the “issuer” (the deposit-taking corporation) does not take the underlying securities onto its balance sheet, but rather acts as a facilitator. The non-resident debtor is the issuer of the underlying securities (External Debt Guide Appendix I).
Securities repurchase agreements
2.16 A securities repurchase agreement is an arrangement involving the provision of securities in exchange for cash with a commitment to repurchase the same or similar securities at a fixed price either on a specified future date, or with an “open” maturity. Securities lending with cash collateral and sell / buy-backs are terms for different arrangements with the same economic effect as a securities repurchase agreement. Economic ownership of the securities provided as collateral under securities lending arrangements, including a securities repurchase agreement, is considered not to have changed because the cash recipient (the seller of the securities) is still subject to all market risks (and also obtains all the benefits). Therefore, transactions involving repurchase agreements and securities lending do not include new debt securities issues, but rather the incurrence of collateralised loans. Hence, these transactions are excluded from debt securities statistics.