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What are interest-bearing securities?

Interest-bearing securities take many forms and can be issued by a range of different institutions. The most common type is bonds.
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© RMIT 2021

Before looking at ways you can put capital to work by borrowing and lending in DeFi, it’s a good idea to review how it works in conventional financial markets, or ‘CeFi’. In CeFi, interest-bearing securities are a class of financial instrument whereby as an investor, you effectively lend money to a company or institution that pays you interest in a prescribed way over a prescribed period of time.

Interest-bearing securities take many forms and can be issued by a range of different institutions including governments, corporations, financial institutions of all types, semi-government bodies and utilities, among others. Notwithstanding the variety of forms and issuing institutions, they are all forms of debt and as such represent a contractual claim over the future cash flows of the issuer.

It’s important to distinguish an interest-bearing security from a loan contract – while both are about lending money on specified terms, the methods differ. We generally understand loans as being made by financial institutions, primarily banks. Interest-bearing securities provide a way for issuers to raise debt finance from other sources such as managed funds and other investment firms, governments, some corporations, and even high-net-worth individuals. Interest-bearing securities make it possible for ‘anyone’ to be a lender.

Other features that distinguish interest-bearing securities

  • In interest-bearing securities, funds are raised by issuing (selling) a financial instrument to a buyer (lender) that represents a promise by the issuer (borrower) to make interest-only payments throughout the term of the security (typically six-monthly) and repay a specified principal amount at the end of its term (at ‘maturity’). In the case of loans (such as mortgages, car loans), the principal amount is generally borrowed up-front at the start of the loan, and principal-and-interest is repaid progressively, usually monthly or fortnightly, throughout the term of the loan;
  • Loans usually involve some form of collateral asset pledged as security, that can be claimed by the lender in the event of default. Interest-bearing securities typically do not, instead they simply represent a promise by the issuer to repay interest and principal according to the specified terms;
  • Where loans are usually made directly between the lender and the borrower and loan contracts are commonly held as assets of the lender for their full term1, interest-bearing securities can be traded in secondary markets. The ultimate holder of the security that receives the principal when it matures may be many trades removed from the original buyer (lender).

Bonds

Bonds are the most common forms of interest-bearing securities. The basic and most common form of bond has a fixed term to maturity, carries a fixed interest rate (called a ‘coupon rate’) and prescribed payment frequency (usually six-monthly) hence the term ‘fixed interest, and a prescribed principal amount that is repaid at the end of the bond’s term2. Bonds vary widely in term to maturity, with some bonds as short as three years and long-term bonds ranging up to 30-40 years.

In the case of bonds and other fixed-income securities, the amount you invest (or lend) is determined by the present value of the promised future cash flows. We should also mention ‘money market’ securities here – which are shorter term securities of up to one year to maturity. Typical forms are Treasury Bills or Treasury Notes issued on behalf of government, as well as Bills of Exchange, Bank Bills and Promissory Notes that may be issued by finance firms and other corporations. Like bonds, money market instruments prescribe a principal amount that is repaid at maturity, and the amount you invest or lend is determined by the present value of future cash flows, but unlike bonds they do not prescribe interest payment during their term. Instead the ‘interest’ earned on the investment is captured by the difference between the present value you invest today, and the maturity value you receive at the end of the term. So while not ‘interest bearing’ per se, they are an important source of shorter-term debt financing for firms and an important source of opportunities for investors.

How to invest in interest-bearing securities

We mentioned that interest-bearing securities make it possible for ‘anyone’ to be a lender, but there are caveats on that statement. Most bonds and money market securities are what we refer to as ‘wholesale’ or ‘professional’ market investments. That is, they are mainly issued, bought, and traded between larger institutions and in large amounts. While in share markets a minimum ‘marketable parcel’ may be $500 or so, in wholesale bond and money markets, $5M or more will constitute a minimum marketable parcel.

A further important feature of buying and selling these securities is that (unlike shares) most trade happens in what we call “Over-The Counter” (OTC) markets, meaning that issuance and ongoing trade occurs directly between buyers and sellers via professional platforms in the wholesale markets (picture the busy treasury dealing rooms you often see on the finance news). These markets are generally only accessible to governments, corporations, financial institutions and (some) very high-net-worth individuals.

That is not to say that smaller, ‘retail’ investors are completely excluded from accessing the opportunities that interest-bearing securities provide. Some bonds are available to be traded on stock exchanges (‘exchange-traded bonds’). In some jurisdictions governments issue small denomination bonds ($1001 -$10,000), and financial institutions issue smaller denomination “Certificates of Deposit” (CDs) to facilitate access for retail investors. These notwithstanding the main way in which retail investors access bond and money market investment opportunities is by investing in managed funds that specialise in these investments.

Notes

  1. Many lending institutions can and do on-sell their loans in various ways, the motives, and mechanisms for doing so are beyond the scope of this course.
  2. While fixed-term, fixed interest bonds are most common, there are many variants, including debentures, secured corporate bonds, floating rate bonds, perpetual bonds, among others.
© RMIT 2021
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