A debt instrument is a fixed-income asset that legally obligates the debtor to provide the lender interest and principal payments.
A debt instrument is a tool an entity can use to raise capital. It is a documented, binding obligation that provides funds to an entity in return for a promise from the entity to repay a lender or investor in accordance with the terms of a contract.
Key Features:
- A debt instrument is an asset that individuals, companies, and governments use to raise capital or to generate investment income.
- Investors provide fixed-income asset issuers with a lump sum in exchange for interest payments at regular intervals.
- Fixed-income issuers repay the full principal balance of a bond or debenture at the maturity date.
- Credit facilities such as mortgages, loans, lines of credit, and credit cards are also considered debt facilities.
How do Debt Funds work
Debt funds invest in a variety of securities, based on their credit ratings. A security’s credit rating signifies the risk of default in disbursing the returns that the debt instrument issuer promised.
The fund manager of a debt fund ensures that he invests in high rated credit instruments. A higher credit rating means that the entity is more likely to pay interest on the debt security regularly as well as pay back the principal upon maturity.
Debt funds which invest in higher-rated securities are less volatile when compared to low-rated securities. Additionally, maturity also depends on the investment strategy of the fund manager and the overall interest rate regime in the economy.
A falling interest rate regime encourages the fund manager to invest in long-term securities. Conversely, a rising interest rate regime encourages him to invest in short-term securities.
Advantages of Debt Instruments
Tax Benefit for Interest Paid:- In debt financing, the companies get the benefit of interest deduction from the profit before the calculation of tax liability.
Ownership of Company:- One of the major advantages of debt financing is that the company does not lose its ownership to the new shareholders as the debenture does not form part of the share capital.
Flexibility in Raising Funds:- Funds can be raised from debts instruments more easily as compared to equity funding as there is a fixed rate of interest payment to the debt holder at regular intervals
Easier Planning for Cashflows:- The companies know the payment schedule of the funds raised from debt instruments such as there is an annual payment of interest and a fixed time period for redemption of these instruments, which helps companies to plan well in advance regarding their cash flow/funds flow status.
Periodic Meetings of Companies:- The companies raising funds from such instruments are not required to send notices, mails to debt holders for the regular meetings, as in the case of equity holders. Only those meetings which affect the interest of the debt holders would be sent to them.
Disadvantages of Debt Instruments
Repayment:- They come with a repayment tag on them. Once funds are raised from debt instruments, these are to be repaid on their maturity.
Interest Burden:– This instrument carries an interest payment at a regular interval, which needs to be met for which the company needs to maintain sufficient cash flow. Interest payment reduces the company profit by a significant amount.
Cashflow Requirement:- The company needs to pay interest as well as the principal amount for the company to keep the cash flows for making these payments well in time.
Debt-Equity Ratio:- The companies having a larger debt-equity Ratio are considered risky by the lenders and investors. It should be used up to such an amount, which does not fall below that risky debt financing.
Charge Over the Assets:- It has a charge over the companies assets, many of which require the company to pledge/mortgage their assets in order to keep their interest/funds safe for redemption.
Examples of Debt Instrument
We have listed some of the most common examples of debt instruments you can find in the financial industry from fixed-income assets to other types of facilities.
Bonds
Bonds are issued by governments or businesses. Investors pay the issuer the market value of the bond in exchange for guaranteed loan repayment and the promise of scheduled coupon payments.
This is the annual rate of interest that a bond pays. It is generally expressed as a percentage of the bond’s face value.
This type of investment is backed by the assets of the issuing entity. If a company issues bonds to raise debt capital and declares bankruptcy, bondholders are entitled to repayment of their investments from the company’s assets.
Debentures
Debentures are often used to raise short-term capital to fund specific projects. This type of debt instrument is backed only by the credit and general trustworthiness of the issuer.
Both bonds and debentures are popular among investors because of their guaranteed fixed rates of income. But there is a distinction between the two.
The primary difference between a debenture and other bonds is that the former has no asset backing it or collateral. The bondholders’ investment is expected to be repaid with the revenue those projects generate.
Remember, if you invest in a debt instrument such as a bond, you become the lender but you become the borrower when you need capital, as is the case with a loan or credit card.
Other Types of Debt Instruments
Banks and other financial institutions also issue debt instruments. Most consumers, though, know these as credit facilities.
Consumers apply for credit for a number of reasons, whether that’s to purchase a home or car, to pay off their debts, or so they can make large purchases and pay for them at a later date.
Mortgages
These debt instruments are used to finance the purchase real estate—a piece land, a home, or a commercial property. Mortgages are amortized over a certain period of time, allowing the borrower to make payments until the loan is paid off.
Lenders also receive interest over the life of the loan. The risk of default is reduced for the lender because mortgages are collateralized by the real estate itself.
This means if the debtor stops paying, the lender can begin foreclosure proceedings to repossess the property and sell it to pay off the loan. The lender is free to pursue the borrower for any remaining balance.
Loans
Loans are possibly the most easily understood debt instrument. Most people use loans at some point. They can be acquired from financial institutions or individuals and can be used for a variety of purposes, such as the purchase of a vehicle, to finance a business venture, or to consolidate their other debts into one.
Under the terms of a simple loan, the purchaser is allowed to borrow a given sum from the lender in exchange for repayment over a specified period of time. The purchaser agrees to repay the total amount of the loan, plus a pre-determined amount of interest for the privilege.
Lines of Credit (LOC)
Lines of credit give borrowers access to a specific credit limit issued based on their relationship with a bank and their credit score.
This limit is revolving, which means the debtor can draw on it regularly as long as they maintain their payments. Just like other credit facilities, borrowers pay principal and interest.
LOCs may be secured or unsecured based on the needs and financial situation of the borrower.
Credit Cards
A credit card provides a borrower with a set credit limit they can access continuously over time. Like a line of credit, consumers are able to use their credit cards as long as they make their payments.
Borrowers have two payment options: They can pay the balance in full each month and avoid paying any interest charges or they can make the minimum monthly payment.
This option means the cardholder carries the remaining balance over to the next month. As such, they are responsible for any interest added as per their cardholder agreement.
Summary
- Debt instruments are fixed-income assets that legally obligate the debtor to provide the lender interest and principal payments.
- When a company wants to raise capital, they can opt to raise capital by using internally generated funds, equity financing, and debt financing.
- Debt financing can be a great source of risk for businesses, primarily through increased liquidity and solvency risk.
Conclusion
Debt instruments allow the issuer to raise capital for a variety of reasons. They often come in the form of fixed-income assets such as bonds or debentures. In other parts of the financial industry, financial institutions issue them in the form of credit facilities.
Related: Index Fund vs Mutual Fund
What Is a Debt Security?
A debt security is a more complex form of debt instrument with a complex structure. It allows the borrower to raise money from multiple lenders through an organized marketplace.
