All You Need To Know About Debt Securities
There is understandably a bit of confusion when it comes to this question. The question reads: If interest rates rise, what will typically happen to debt security prices?
The answer is that the price of debt securities will fall.
You may be wondering, but what is this asking me? What is the relationship between the price of debt securities and interest rates? Below we’ll give you a little more info to help you understand.
Firstly, what is debt security?
Debt security is defined as a financial instrument representing a legally binding loan agreement between a creditor and a debtor. Where a creditor is the ‘buyer’ or ‘investor’ and the debtor is an ‘issuer’. In return for the loan, the buyer (creditor) will receive interest or a discount from the par value at a specified rate and time. This is more or less how loans work in a general sense.
Now what is interesting about this is that there is an inverse relationship that develops between debt securities and interest rates. What does this mean? Why does this happen? This means that when the one rises the other falls, as in, when the interest rate rises, the price of debt securities fall and when the interest rates fall the price of debt securities rises.
Why does this happen? Let’s look at it this way… If the interest rates are currently considered ‘high’, this then means that an individual would have to pay higher repayments for a specific loan (or debt security). This will therefore have an effect whereby the prices of the loans would decrease as there is less demand for these loans. In the economy it is important to remember that it is all circulating around a balance of demand and supply. So, when it essentially becomes more expensive to pay back loans (i.e., due to the high interest rates) there will be fewer people able to purchase these debt securities and therefore the interest rates will decrease. The interest rate decreasing acts as an attraction and motivation for individuals to take out loans, so that the demand and supply can reach an equilibrium once again.
It is important to remember that the economy is never static, it is always moving, changing, and adapting to the external environment. When Covid-19 hit South Africa and the world it was clear that the economy would take a toll, individuals have not been able to meet their specific loan repayments due to a limitation or lack of income… So, what has happened to the prices of debt securities and the interest rates? At the moment we have seen that it is ‘cheap’ to take out loans (or debt securities) as the interest rates are currently very low. This is to try and stimulate the economy again after such an economically devastating time.
Has this explanation helped you understand the question regarding the prices or debt securities and the interest rates? If you are still feeling unsure about the concept, please feel free to reach out for further clarification. There are also lots of resources explaining financial concepts online which you may find useful!