Bonds and Debt Instruments

What are debt instruments?
Debt instruments such as bonds, bills and commercial paper are loans that governments or corporations take from investors. The difference between ordinary loans and most debt instruments is that these instruments can be traded on the secondary market, i.e. between any two entities without the explicit consent of the issuer (entity that has taken the loan).

Corporations and governments often need capital in order to meet their expenditure, plan new projects or meet obligations. One way they raise capital is to issue bonds

Terminology
Face Value or par value: The notional value of the bond/instrument. This is the amount that will be paid to the instrument holder upon maturity. Coupon payments are also calculated based on this amount as the principal.

Coupon: Periodic interest payments paid to bondholders. Most coupon payments are semi-annual i.e. twice a year.

Yield: Yield can be thought of as the compound interest rate that is received from the investment, which takes into account, the coupon payments and discount/premium from the par value.

(Technically speaking, yield is the discount rate that makes the present value of future cash flows received from the investment, equal to the current price of the instrument)

Maturity: The time period after which the face value of the bond is returned to the bondholder and by which time all coupon payments are paid.

Issuer: The corporation or government that takes the loan from the investor.

Discounted Instruments: Instruments that are issued at prices below their par value.

Credit Ratings: Ratings that are given to debt instruments by specialized rating agencies that indicate the probability of default and the likelihood of recovery of the amount due to the bondholder in case of default by the issuer.

Major types of Debt Instruments

Bonds
Bonds are debt instruments with moderate-long maturities issued by governments and corporations. Bonds pay face value at maturity along with periodic interest payments known as coupon payments.

Debentures/ Notes
Debentures are unsecured promissory notes with long maturities usually issued by corporations. Debentures are considered more risky than secured forms of lending and thus tend to pay higher interest than collateralized loans.

Bills Bills are short term loans usually issued by governments. These are generally discounted securities.

Commercial Paper
Commercial papers are unsecured short term securities (maturities below 9 months) issued by banks and corporations with very high credit ratings to meet short term obligations such as debt and payrolls. Most commercial paper is sold at a discount to par value.

How individual investors can invest in debt instruments
Individual investors can invest in debt instruments either through the issuer directly or through a broker on the secondary market. Investors can also invest in mutual funds that invest in debt securities.

Advantages

1. Debt instruments are generally safer than stocks. Instruments issued by entities with good credit ratings are usually very safe.
2. Most debt instruments such as bonds are fairly liquid and can be traded on the secondary market.
3. Bonds and debentures pay higher interest than cash equivalents.

Disadvantages

1. Debt instruments, carry credit risk i.e. risk of default.
2. Junk bonds (Credit rating lower than BBB) are very risky and have often been defaulted upon.
3. Some debt instruments are illiquid, especially those with low credit ratings.
4. Debt instruments carry interest rate risk i.e. the risk that the interest rates required by the market rise, thereby reducing the value of existing investments.

Risks

1. Credit Risk: Credit Risk is the risk of the issuer defaulting on the principal repayment or the coupon payment.
2. Interest Rate Risk: Interest rate risk is the risk of the market interest rates rising, thereby reducing the market price of existing interest bearing investments.
3. Liquidity Risk: Liquidity risk is the risk that the debt instrument cannot be traded quickly in the market due lack of sufficient interest from potential buyers.

Next: Cash Equivalents