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I have a teams site for external users, with a library where they can download reports. They only need 'read' permissions on this site.

Do I add them to the Sharepoint (OOTB) visitors group? Or add them to the existing M365 site's security group, as visitors? Or do I create a separate security group for them in M365?

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You can add them to the SharePoint visitors group or create a group in site and grant the group read permission. What matters is not what group they are but the permission levels they have. Groups are just a way to make it easier to manage users, by putting users with the same permission levels in a group and giving them the same permissions.

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