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Guide to Debt Instruments

What Are Debt Instruments & What Do They Do?
Lauren Ward
Lauren WardUpdated May 4, 2022
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A debt instrument is a contract that enables one party to loan funds to another party, who promises to repay the loan plus interest. Debt instruments are also referred to as fixed-income assets because the lender receives a fixed amount of interest during the lifetime of the instrument.Debt instruments come in many forms. Some are obvious, such as mortgages and different types of small business loans; while others are less so, such as rental leases, bonds, and treasuries. With some debt instruments you are the borrower (such as when you take out a mortgage or credit card). In other cases, you are the lender, such as when you purchase a bond or treasury. Regardless of what side of the deal you are on, debt instruments are a financial valuable tool in today’s world.   Here’s what you need to know about debt instruments, including the definition of debt instrument, different types of debt instruments, how these instruments work, and the pros and cons of debt financing.

What Are Debt Instruments?

A debt instrument is a fixed income asset that legally binds a debtor to pay back any amount borrowed plus interest. Debt instruments can be issued by individuals, businesses, local and state governments, and the U.S. government. Businesses often use debt instruments to raise capital to purchase additional assets (such as manufacturing equipment) or to raise working capital, while local governments may do so to fund the building of infrastructure (such as a new highway or a bridge). Debt instruments also give participants the option to transfer the ownership of debt obligation (or instrument) from one party to another. Debt instruments can be short-term (repaid within a year) or long-term (paid over a year or more). Credit cards and treasury notes are examples of short-term debt instruments, while long-term business loans and mortgages fall into the category of long-term debt instruments. 

How Do Debt Instruments Work?

If you’ve ever taken out a loan or credit card, you probably already understand the basics of how debt instruments work. Debt instrument contracts include detailed provisions on the deal, including collateral involved, the rate of interest, the schedule for interest payments, and the term of the loan (or timeframe to maturity). While any type of vehicle classified as debt can be considered a debt instrument, the term is most often applied to debt capital raised by institutions, such as companies and governments. In this scenario, the investor is the lender: You issue money to a business, municipality, or the U.S. government. In exchange for capital, you are paid back the amount you loaned over time with interest. Examples of this type of debt instrument include U.S. treasuries, municipal bonds, and corporate bonds.

Types of Debt Instruments

Below is a breakdown of some of the most common debt instruments used by individuals, governments, and companies to raise capital.

U.S. Treasuries

U. S. Treasury securities (also called treasuries) are government debt instruments issued by the U. S. Department of the Treasury to finance government spending as an alternative to taxation. Treasury securities are backed by the full faith and credit of the U.S., meaning that the government promises to raise money by any legally available means to repay themU.S. treasuries tend to be more affordable than many other debt instruments. Investors can buy them in increments of $100 either through brokerage firms, banks, or the U.S. Treasury website. There are three types of treasuries: treasury bills, treasury notes, and treasury bonds. Each treasury comes with its own maturity option.

Municipal Bonds

Municipal bonds are offered by various U.S. government agencies (towns, cities, counties, or states) to fund current and future expenditures. Programs often funded by municipal bonds include the building of schools, roads, and bridges. Think of a municipal bond as a loan an investor makes to a local government.There are two types of municipal bonds: general obligation bonds and revenue bonds. General obligation bonds are not paid back by any revenue resulting from the completion of the project. Instead, they are paid back to investors through property taxes or overall general funds. Revenue bonds are paid back by the issuer through either sales, taxes, or some other type of revenue generated by the project. Municipal bonds are attractive to many investors because they are tax exempt bonds — meaning the investor doesn’t have to pay taxes on any interest received. 

Corporate Bonds

A corporate bond is a debt security that a corporation can use to raise money. Funding is typically available to anyone who is interested. As with other bonds, corporate bonds are essentially an IOU from the company to the investor. It differs from stock in that, instead of being paid dividends when the company is profitable, investors are always paid regardless of whether the company is doing well. Typically, corporate bond investors are paid interest until the bond matures. When it matures, the entire principal is paid back. For example, a $1,000 corporate bond with an interest rate (or coupon rate) of 5%, would bring an investor $50 every year until the bond matures. This means that, after 10 years, the investor would see a gross return of $500. With secured bonds, the company puts up collateral (such as property or equipment) as security for the bond. If the company defaults, secured bond holders can foreclose on the collateral to reclaim their money. With an unsecured bond, a holder may or may not be able to fully reclaim their investment.

Alternative Structured Debt Security Products

There are many types of structured debt security products on the market, many of which are issued by financial institutions. A common occurrence is for these institutions to bundle assets together as a single debt security product. By doing this, they are able to raise capital for the financial institution while also segregating the bundled assets. 

Leases

A residential or commercial lease is a legally binding contract between an owner of a property and a tenant where the tenant agrees to pay money for a set period of time in exchange for use of the rented property. A lease is a type of debt instrument because it secures a regular payment from the tenant, thus creating a secured long-term debt. 

Mortgages

Mortgages are a type of debt instrument used to purchase either a home, commercial property, or vacant land. The loan is secured by the property being purchased (which the lender can seize if the borrower defaults on the loan). As with many other consumer loan products, mortgages are amortized, meaning the borrower makes a series of equal monthly payments that provides the lender with an interest payment (based on the unpaid principal balance as of the beginning of the month) and a  principal payment that will cause the unpaid principal balance to decrease each month so that the principal balance will be zero at the time of the final payment.When seeking a mortgage, it’s important to shop around and compare mortgage rates. While most lenders base their rates on the going prime rate, some are cheaper to work with than others because of additional costs such as origination and processing fees. 

Pros and Cons of Debt Instruments

Debt instruments can be mutually beneficial in that both parties become better off as a result. If a company takes out a small business loan and invests those funds wisely, for example, it can increase its profitability. Ideally, the increase in profits exceeds the cost of the loan, a concept known as leveraging in business. Borrowing money also allows a company to raise capital without losing equity. Debt instruments also benefit individuals, as well as governments. Without mortgage debt, many people would never be able to buy a house or afford to go to college because it is so expensive compared to income. Debt instruments allow governments to build infrastructure for the public good. On the lender’s or investor’s side, debt instruments can provide a regular and guaranteed source of income and are considered a safe investment, provided the loan is secured.But there are downsides to debt instruments as well. Loans often come with restrictions on how they can be used, for example, and, if you don’t have good credit, interest rates can be high. Borrowing money also involves risk. Most commercial institutions will require you to put up collateral in the form of a property asset. If you lose your income or your business hits hard times and you cannot repay your loan, the lender can reclaim its debt by liquidating whatever you proposed as security, which means you can lose a valuable asset.On the lender’s or investor’s side, debt instruments also come with risk. Unless you purchase a secured bond, you may not receive your principal back as the investor. Also, during periods of high inflation, bonds can actually have a negative rate of return. And, if you invest in corporate bonds, there is always the possibility that the issuer will default on payment.   

The Takeaway

A debt instrument is a way for an investor to get a return on their money by loaning to either an individual, business, municipality, or the U.S. government. If you have a credit card or mortgage, or you own any bonds or treasuries in your investment portfolio, debt instruments play a role in your life.Small business owners can also take advantage of debt instruments. You might not be able to issue corporate bonds at this stage of the game, but you may be able to access an affordable small business loan. If you’re interested in exploring your small business loan options, Lantern by SoFi can help. With our easy online lending tool, you can quickly compare offers from multiple small business lenders with no obligation and only one short application.
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The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice. SOLC0122033

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About the Author

Lauren Ward

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
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