What are the specific features of debt instruments, main benefits, and possible risks?

When it comes to investing, there are two things you should consider – what is it that you want from the investment. Do you want to have ownership over an asset, or do you wish to receive a constant income in exchange for loaning your money? Depending on either, you have two primary instruments in investing - debt instruments and equity instruments. Debt instruments allow you to earn an income in exchange for lending money to a borrower for financial purposes, while equities allow you to own an asset or a part of an asset. Equity instruments we will discuss in another article in detail.

But here, we will explore the intricacies of debt instruments, benefits and risks:

1. Main aspects of debt instruments

Debt instruments are just that - a debt. It is a loan you give to the state or a corporation to earn interest revenue. Whether the state or a company, the issuer borrows capital from investors like you to finance their projects and expand their business. After the agreed term, your principal must be paid back with interest. If the issuer goes bankrupt, you will have a claim over their assets as a lender.

Some debt instruments can be traded on a secondary market and can bring you profit or loss. Since debt instruments carry risk, losses are the consequences every investor should factor.

2. What are the debt-based financial instruments?

The most relevant debt-based financial instruments for an investor are the ones that bring in a fixed income, although some provide a variant income. Some of the well-known examples of debt-based financial instruments are:

  • Bonds
  • Certificate of deposit
  • Alternative structured debt-based instruments

Bonds

Bonds are a common example of a debt instrument. The issuer can either be a corporation or a state, or even a union of states (Eurobond, for example). All issuers issue bonds to collect money from investors to finance their projects. In exchange, they pay the investor a fixed rate (coupon). After the term is over, issuers must pay your principal back with interest. If not, you will have a claim on their assets.

Not all bonds pay a fixed rate, though. Some pay a variable rate, while others do not pay at all. These are known as zero-coupon bonds - those are generally acquired at a discounted rate.

Corporate bonds pay a higher interest rate than state bonds due to their inherent higher risks than state bonds. However, most of the state bonds are not taxed. Corporate bonds are. Corporate bonds carry a higher risk because the government does not support them.

There are a few factors that affect the market price and the interest of bonds. As such, the market price of bonds fluctuates and moves in the opposite direction of the interest rates. So, if the interests are high, then the market price will be lower. Since bonds pay a fixed rate, it is an attractive investment for many, thereby increasing demand and the subsequently, the price of the bonds. Likewise, if interests increase, investors will not invest in fixed interest rates bond and eventually lower the bonds' price. A complicated correlation, but a correlation nonetheless. Their prices are also influenced by the issuer's credit rating (financial health of the issuer). The lower the rating is, the riskier the bonds are, making the issuer promise higher rewards. The higher the rating, the lower the coupon rate is on offer.

Adding bonds to your portfolio is the right choice if you want a predictable and stable income without taking too much risk.

Certificate of deposit

Certificate of deposits is just a savings account in a bank or a credit institution. It usually comes with a higher interest than a regular savings account because the saving has restricted liquidity and is supposed to be frozen for a while. If you withdraw early, you will lose interest.

While it may not seem like an investment due to its savings nature, it is an investment of sorts. It is because you are lending your money to the institution in exchange for an interest. And while the interest may not be higher than other regular investments, the income is not usually the main goal behind a deposit. The maximum protection that banks or credit institutions offer ranges from 20 000 EUR to 100 000 EUR per depositor, depending on the institution and country.

Alternative structured debt-based instruments

Bonds are a traditional debt instrument where the issuer collects money to finance their own operations. On the other hand, alternative debt-based instrument pools capital from investors to finance others' business projects. Examples include:

  • Crowdfunding
  • Peer to peer lending
  • Debt financing-based investment funds

Interests are mostly variable but have some form of fixed basic income. Due to their innovative way of funding, they can allow investors to choose their own loan term, loan projects and even their annual target. They may or may not offer high liquidity. They offer additional monetary incentives to encourage new investors and novices who have never invested before, such as bonuses, low capital requirement, testing grounds, etc.

The returns on risks. The higher the risk, the higher the reward. It also depends on the method of collecting capital and the securities the companies offer. For instance, crowdfunding debt backed by leasing/factoring based financing carries a low risk.

3) What is the risk in debt instruments?

Risks in debt instruments depend on the kind of institution. For instance, certificates of deposits offer maximum protection to your money. However, their interest rates are incredibly low, which does not even compensate for inflation.

Risk-rate for bonds relies on its issuers. Corporate bonds may be risky if the corporation's credit rating is low, even if the interest rate is higher. Likewise, the stability of government bonds depends on the economic situation and the demand. A poor economy will lead to its bonds' downfall in demand, price and interest.

An alternative structure is still quite relatively new. Therefore, people are apprehensive. Risks mostly circumvent around borrowers' default. To prevent defaults, companies are becoming more selective about their borrowers to minimise investor risk. Whether such measures are effective can only be seen in due time.

Debt instruments are a tool that is beneficial to corporations, the state and the investor. Issuers use it to gather capital, and investors invest to earn a fixed income. It gives flexibility to both the borrower and the lender in their structure and usage.

Last update: 05/08/2021

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