InvestorQ : I am planning to invest in bonds and need to understand all the basics pertaining to debt. Can you quickly explain to me what is meant by debt and how debt can help me enhance returns?
Rutuja Nigam made post

I am planning to invest in bonds and need to understand all the basics pertaining to debt. Can you quickly explain to me what is meant by debt and how debt can help me enhance returns?

Arti Chavan answered.
4 years ago

For many borrowers debt has become a four letter word but then debt also has a strong investment implication. Debt is like an IOU and it is given to the lender by the borrower committing to pay a fixed sum of interest on the appointed dates and also pays back the principal on the scheduled date. Debt is the largest category of investment securities in the US investment universe, with securities valued at $39.4 trillion at the end of 2016. That's substantially greater than the US equity market, which was valued at $27.4 trillion.

But while the concepts of risk and return may be common to both debt and equity, debt investment has its own language, principles, and metrics. Familiarity with these unique aspects is important for complete understanding of the market.

Different types of debt investment

Let us look at the different types of debt investments that you can allocate funds to. Simply put, debt represents an IOU given from a company, a government entity, or a private borrower to an investor in exchange for cash. A debt security is generally issued for a fixed term with the intention of paying a predetermined amount of interest on the debt at fixed intervals during the term and then repaying the face value at the end. Within this universe:

Unsecured debt is a general obligation of the issuer and may be repaid out of any available revenue source.

Secured debt, in contrast, is generally tied to cash flow generated by a specified asset.

Debt hierarchy is the term used to describe the priority given to various company obligations when resources might be limited; senior would be the highest-ranking debt in the hierarchy, junior the lowest.

Dimensions of return for debt investment

Periodic cash flows to investors are a primary feature of most debt securities. These cash flows are generally described as yield and typically expressed as a percentage. When comparing yields on different securities, be aware of the many different types of yield and consider the assumptions used to derive each type.

The first is Coupon yield which refers to the annualized interest payment from a debt security when it is expressed as a percentage of the face (or "par") value of that security. The term coupon is a historical remnant of the time when bonds were issued as physical certificates instead of computer records, with pieces of paper meant to be redeemed periodically for cash at the bond's issuer or agent. The coupon yield would not be affected by any subsequent changes in the bond's market value. If a bond were bought when issued (at par value) and then held until redeemed in full at maturity, it would have no capital gain or holding loss and its coupon yield would be its return.

The second is Current yield which is the annualized coupon amount expressed as a percentage of the bond's current market price. While current yield may be a good indicator of a bond's relative current performance, it does not take into consideration reinvestment of interest payments over the life of the bond, nor does it factor in any differential between purchase price and maturity value.

Then there is the most popular Yield to maturity or YTM which is the annualized total return an investor could expect from a bond bought at some price other than par value, assuming that the investor were to hold the bond until it matured and also reinvest its interest payments at the same rate of return. Because yield to maturity takes account of differences between the purchase price and maturity value as well as interest payments, it may provide the most direct means to compare different bond issues in the same market conditions.

Yield to call is similar to yield to maturity, except "maturity" is assumed to be the bond's next call date (and call price). Yield to call is often used for bonds containing call features, especially for higher coupon issues or in a falling rate environment when issuers are more likely to exercise their call options.

Different types of risk in debt instruments

A lot of investors tend to believe that all debt is free of default risk. Only government debt is free of default risk and other forms of debt are subject to risk in some form or the other. Investors in debt must consider a number of risks that are unique to this type of security. Here are some of the widely observed risks that impact broad sections of the market.

Interest rate risk is the possibility that a bond's market value will fall when market interest rates rise. A common measure of interest rate risk is duration (a longer duration suggests greater sensitivity to a given amount of rate change). Interest rate risk is of particular concern if you don't intend to hold a bond until maturity, because any decline in value could represent a loss at sale.

Then of course there is the market risk. The Market risk is the risk that a bond's value may fluctuate with changes in external market conditions such as fear of inflation, economic uncertainty, and market perceptions of the issuer. This has important implications for large investors and institutions that have to make a provision for any MTM losses on their debt holdings. MTM makes a big hit on profits for them.

Credit risk refers to the possibility that a bond issuer will default on a scheduled interest or principal payment, and it varies widely. Independent firms publish credit-quality ratings for thousands of bonds. The lower their rating is on an issue, the greater the presumed level of risk. Only government bonds are free of credit risk and that too only central government bonds. All other bonds have some degree of credit risk or default risk.

Inflation risk is the risk that a bond's total return could be lower than the rate of inflation for the term of the investment. In that scenario, the loss of purchasing power could make the real net present value of a bond investment less than the initial investment outlay.

Call risk is the possibility that the issuer could redeem a bond before its maturity date, reducing the total cash flow of the investment. Moreover, when the value of a called bond cannot be reinvested in another issue with a comparable yield, the differential represents an opportunity cost for the investor.

The overall debt market can be subdivided into sectors representing such different types of debt as investment-grade corporate bonds, high-yield corporate bonds, US treasury bonds, municipal bonds, and many others. Each sector has its own risk and reward profiles. Each also has different federal, state, and local tax consequences for potential income and capital gains. Prospectuses and credit reports can help you understand how these differences might apply to your investment situation.