Debt stinks – unless you're the one collecting the payments, in which case debt can be a steady source of income. That's why people add debt securities to their investment portfolios. You can, too, but you should have an understanding of the terms that get tossed around in debt markets, such as notes, bonds, debentures and commercial paper.
What Are Bonds?
Debt markets are often just called "bond markets." When you buy a bond, you're lending money to an organization such as a corporation or a government. The bond is a written promise from the institution borrowing the money to repay the loan on a certain date, called the maturity date. Usually, a bond also includes a promise to pay interest in regular installments – in most cases, every six months or once a year.
What Are Notes?
Notes and bonds are pretty much two flavors of the same thing. Both promise to repay borrowed money, and both will usually pay interest. The distinction is that a note has a shorter maturity than a bond. How much shorter depends on the issuer.
For municipal securities – those issued by cities and states – "notes" are generally defined as those that mature in a year or less. The U.S. Treasury defines a Treasury note as a security with a maturity of two to 10 years; anything longer than that is a Treasury bond, and anything shorter is a Treasury bill, or "T-bill." Corporate notes are generally categorized into short-term notes, with maturities up to five years, medium-term notes, with maturities of five to 12 years, and long-term notes, with maturities longer than 12 years.
What Are Debentures?
So now you've got a bond or note that says you're going to get money from the issuer. Perhaps you're wondering where the money will come from – good question. Sometimes, the bonds are "revenue bonds," meaning the money will come out of revenue generated by the very project the bonds paid for. With "asset-backed" securities, the money might come from payments on consumer loans.
But in many cases, debt securities aren't actually backed by anything except the issuer's promise to pay. They are unsecured debt, meaning there's no collateral behind them. Unsecured bonds and notes are called "debentures."
What Is Commercial Paper?
Companies issue bonds and notes to pay for specific projects, such as big capital investments or debt restructurings. But sometimes companies need a short-term infusion of cash to buy inventory or cover regular fluctuations in cash flow, and they'd prefer not to have to jump through the hoops that banks and bond-market regulations require.
That's where "commercial paper" comes in. These are extremely short-term notes with maturities of nine months or less – often much less. If your investments include "money market" funds, you may well have some money tied up in commercial paper.
Risks and Returns
The returns you can reasonably expect to get from investments in debt securities vary according to the risk you take. The more risk, the more return you should expect to get. Credit rating agencies assess how likely issuers are to default on their obligations, and assign them credit ratings that range from triple-A, the best, down to "junk" ratings. Risk also increases with maturity. The longer the wait till maturity, the higher the risk – not only because something could happen that causes the issuer to default, but also because you've got your money tied up and you can't seize other opportunities.
Commercial paper offers a lower return than two-year notes, which pay less than long-term bonds. But even "risk-free" U.S. Treasury securities have to compensate investors for tying up their money.