You've probably come across debt at some point in your life. Debt provides liquidity to the financial markets by giving borrowers access to the capital they need. Individuals, businesses, and governments use debt instruments for a variety of reasons.
These instruments come in a number of different forms—some more obvious than others. Keep reading to find out more about debt instruments and the most common types issued by lenders.
Key Takeaways
- 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.
What Is a Debt Instrument?
A debt instrument is an asset that an entity, such as an individual, business, or the government, uses to raise capital or to generate investment income. For instance, a company may need to finance the purchase of a new piece of equipment, while government agencies may require financing for projects such as infrastructure improvements or to fund their day-to-day operations.
This type of instrument essentially acts as an IOU between the issuer and the purchaser. The purchaser becomes the lender by providing a lump-sum payment to the issuer or borrower. In exchange, the issuing company guarantees the purchaser full repayment of the investment at a later date. The terms of these types of contracts often include the payment of interest over time, resulting in cumulative profit for the lender.
A vehicle that is classified as debt may be deemed a debt instrument. These range from traditional forms of debt including loans and credit cards, and fixed-income assets such as bonds and other securities. As noted above, the premise is that the borrower promises to pay the full balance back with interest over time.
Below, we list 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.
Fixed-Income Assets
These assets are investment securities offered to investors by corporations and governments. Investors purchase the security for the full amount and receive interest or dividend payments over regular intervals until the instrument matures.
At this point, the issuer repays the investor the full principal amount invested. Bonds and debentures are among the most popular types of fixed-income debt instruments.
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.
Banks use the money they receive from savers to lend out to others. Banks receive interest on top of the principal they lend out, a small portion of which is deposited into their clients' savings accounts. These can be collateralized or not based on the type of facility and the borrower's credit history.
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.
Here's an example of how they work. Let's say Mr. Chan has a $20,000 LOC. He uses it to pay down some debt, buys some furniture, and pays a contractor for some work around his home. This totals $11,000. Mr. Chan still has $9,000 available. But if he makes a $5,000 payment to pay down his balance, he has access to $14,000 that he can use freely.
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.
The Bottom Line
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.
In both cases, the borrower agrees to repay the lender the principal balance plus any interest by a certain date.
