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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 lending your money? Depending on which one you choose, you have two primary instruments for 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 and their benefits and risks:

What are 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 it's 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 a profit or loss. Since debt instruments carry risk, losses are the consequences every investor should factor in.

Understanding debt instruments

Institutional debt capital is the primary focus of debt instruments because they come with a pre-determined payback schedule and less risk, which means lower interest payments. Different types of debt instruments have a significant impact on the issuance markets for structured companies. Credit cards and credit lines are two examples of debt instruments that a business might use to raise money. It is common for these revolving lines of credit to have a simple structure and only one lending institution. Credit cards and lines do not have a primary or secondary market structure.

Advanced contract structuring and the involvement of many lenders or investors, usually through an organised marketplace, are required for more complicated debt instruments. Debt securities, for example, are a more complicated form of debt instrument that requires more comprehensive structuring. Debt security instruments are structured to be issued to a large number of investors.

Characteristics of debt instruments

The five major aspects of debt instruments are discussed in this article:

  • Interest rates: Interest rates can be fixed or variable. Call rates, bank rates, and government security rates all influence variable rates. Inflation-linked interest rates are also available, ensuring that real interest rate returns are not affected by inflation. Then there is the coupon rate, which refers to the specified interest rate on the debt instrument. There are some debentures and bonds that are issued with step-up coupons, which have a variable interest rate that fluctuates over the course of the maturity period.
  • Security: Debt security, like bonds, can be secured or unsecured. As opposed to the more traditional methods of securing collateral, some of the new instruments are structured with a charge on receivables relating to specific activities or created in a specific area. It is typical for securitised bonds to be issued through a special purpose vehicle or business that holds an underlying asset that is used to meet the bond's obligations. For example, a bank could issue bonds that represent all of its outstanding mortgages. Issuers favour securitised bonds because they improve their credit and allow them to access the existing assets' liquidity.
  • Options: Debt instruments often have Options. The term "convertibility option" refers to the option of converting some or all of a company's debt into equity. It is possible to redeem the investment at a predetermined date, or for a predetermined amount of time, before the maturity date of the instrument. This gives issuers and holders of debt the ability to take advantage of changing market conditions.
  • Taxes: Certain securities have had income and capital gains taxes waived, which resulted in lower issue costs and higher pretax yields for the holder. Tax-free bonds and debentures are in direct competition with tax-free redeemable preference shares, whose dividends are likewise tax-free.
  • Risks: The risk weight of bonds and debentures can also vary in relation to the capital adequacy requirements of banks. A bank's risk-weighted assets are its loans and other assets, weighted to reflect the bank's risk of loss.

Advantages of debt instruments

Different debt assets offer different advantages to investors. It is important to understand this before investing in debt instrument. Bonds, for example, are less risky than stocks while still paying a steady return. Credit cards and other forms of consumer debt help you build your credit score, which opens the door to better financial opportunities like lower-interest mortgages.

For a company, profitability can rise if it uses debt instruments to invest borrowed capital appropriately. This is known as Leverage where companies borrow money from creditors to increase shareholder wealth. If the debtor's investment returns exceed the interest payments, he or she will be able to profit from borrowing money. As a result, loan interest can be deducted from taxable income.

Disadvantages of debt instruments

Debt investment has disadvantages for both the investor and the business. For an investor, the disadvantage lies in the debt based assets themselves. For instance, certificates of deposit offer maximum protection for your money. However, their interest rates are incredibly low, which does not even compensate for inflation. The cons of bonds depend on their issuers. Corporate bonds may be risky if the corporation's credit rating is low, even if the offered interest rate is higher. Likewise, the stability of government bonds depends on the economic situation and demand. A poor economy will lead to its bonds' downfall in demand, price, and interest.

An alternative debt-based investment structure is still relatively new. Therefore, people are apprehensive. Risks are mostly circumvented around borrowers' defaults. 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.

The increased liquidity and solvency risk that comes with debt financing is a major concern for firms. Interest payments are considered a current liability, which means that they will deplete a company's cash reserves within a year. Additional collateral and personal guarantees may also be requested by lenders when they lend money to small businesses.

Types of debt instrument

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 be either 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." These 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 rate on bonds. As such, the market price of bonds fluctuates and moves in the opposite direction of interest rates. So, if interest rates 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 savings 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.

What are the risks in debt instruments?

Debt instruments are not as risky as equities, but they are not completely risk-free either. On the contrary, here are some of the risks of debt instruments:

  • Default risks: The risk of default arises when a corporation is unable to make both the maturity payment and the coupon payment. Sovereign papers, on the other hand, carry no risk. The lower your investment's default risk, the higher the rating of the instrument you purchased. When it comes to protecting against the risk of default, a debt instrument with a AAA rating is superior to a debt instrument with an AA rating. Keep in mind that a company's credit rating is based on both its past and present financial health. No indication of future returns or a guarantee against future default is provided by this document.
  • Interest rate risk: Interest rate volatility affects debt instruments. Interest rates and bond prices have an inverse relationship. Bond prices fall when interest rates rise, and vice versa. Only instruments with a current market price are subject to this level of volatility. A rise in interest rates has no effect on your returns if you retain a bond until it matures. Interest rate changes can only affect your returns if you sell the bond before its maturity. Fixed deposit returns aren't affected by interest rate risk because they aren't tied to the market.
  • Inflation risk: Inflation has made debt instruments prone to inflation. The longer the bond's tenor will be, the higher the likelihood that inflation may affect your real rate of return.
  • Call risk: This refers to the issuer's right to buy back the bonds it has issued to investors before the tenor of the bond has expired. This is the polar opposite of a put option, which gives the investor the chance to cash out early if he or she so chooses. There is a predetermined time period after which calls or puts become active, as stipulated in the offer document. It is common for bond prices to rise when interest rates are predicted to fall in the future. Investors get their money back and the corporation may issue another bond at a reduced interest rate after exercising its call option. In this instance, you are refunded your initial deposit. However, not all bonds have the option to call.

Summary

The purpose of debt instruments is to raise capital in exchange for a steady income provided to the creditor. The creditor may be a country or a company that borrows to finance projects. Their interest rates may be fixed or variable, and these instruments can be secured or unsecured by collateral. Some debt instrument assets can even be converted into equities. Not to mention, some of them, like municipal bonds have tax exemptions. Both borrowers and lenders can benefit from debt instruments. The lender receives an income for loaning money while the borrower gets to finance their project. On the flip side, debt instruments have default risks, meaning the borrower can default on their payments. They are also prone to inflation, which cannot be compensated for by the growth rate of the debt asset. The most common examples of debt instruments are bonds, certificates of deposit and alternative investments.

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.

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