What are Debt Instruments? Who Should Invest in Them?

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Investors often get confused about whether they should invest in significantly high risk-high return instruments. Often, they end up not investing, due to this inhibition.

 

It also happens quite often that low-return investments are not very attractive, or they don’t help individuals reach their financial goals on time and high-return investments are risky.

 

What if we tell you there is a middle way through which you can invest in instruments that give you decent returns and at the same time, help you reach your financial goals?

 

Let’s know more.   

What are Debt Instruments? 

Debt instruments are generally issued for a shorter period of time and they carry lesser risk than stocks. Yet, they offer considerably good returns. This blog aims to provide you with information you should know about debt instruments, who should invest in them, and why.

 

We will also talk about the risk involved in the debt instruments so that your investment decision becomes more accessible. 

 

Debt instruments are one of the most effective ways to raise funds for business expansion. The issuer of debt instruments list them at a fixed rate so that investors get regular fixed interest. 

 

 Fixed-income instruments carry  relatively lower risk as compared to equity instrument of the same issuer. These instruments offer regular interest income to the investor. The principal is returned after a maturity period which is generally short-term.  

 

Also known as relatively ‘safer’ investment options by investment experts, debt instruments are generally neutral to market fluctuations.

 

They are pretty consistent in giving returns as market volatility does not effect them as much. The coupon offered by debt instruments is normally neutral to market fluctuations. 

 

Types of Debt Instruments

 

Debt instruments are like loans that you give companies or the Government or Government-backed companies. Such instruments cushion your portfolio to balance the risk of market volatility. 

 

Different types of debt instruments include fixed deposits, bonds, debentures, treasury bills, G-Sec, debt mutual funds, etc. Let us have a look at these types.

 

1. Bonds

Bond is the most common debt instrument that offers a fixed interest rate and returns the principal amount after the maturity period is over.  

 

The risk of investing in bonds depend on whom you have given your money to. If you have invested in government bonds, there is  very little risk of non-payment.  And the risk is relatively higher if you have invested in corporate bonds, which operate in the private sector.

 

2. Fixed Deposits

Fixed Deposits are majorly of two types, corporate or bank FDs.

 

FDs also have a fixed interest rate that you can decide to receive monthly, quarterly, annually, semi-annually, or compounded until maturity. 

 

Bank FDs are considered one of  the safest investment options, but the returns generated by FDs are significantly less.

 

3. Debentures

Debentures are secured or unsecured instruments through which companies can raise money. In India, the term secured debenture and bonds are used interchangeably.

 

You get coupon payments on a regular basis like bond the category  in debt mutual funds

 

Debt mutual funds hold a portfolio of securities in which the money is primarily invested in debt securities such as government bonds, treasury bills, corporate debentures  etc. Since there is a variety of debt instruments involved in a debt mutual fund, it offers moderate returns.  

 

However, you pay some cost to the AMC (asset management company) by way of an expense ratio. Debt Mutual Funds also carry moderate risk in general and offer moderate returns. 

 

Who Should Invest in Debt Instruments and Why?

 

why-invest-debt

 

Debt instruments are for everyone.

 

They are investment options in which every investor should consider putting some amount of money in, in order to balance their portfolio. If an investor does not have equity exposure, then also debt instruments have the potential to offer less risky and regular income products.

 

As a new investor, debt instruments give you fixed income at regular intervals. While as a seasoned investor, debt instruments cover your portfolio from the potential risks that market fluctuations pose. However an investor must always remember to never time the market.

3 Reasons Why You Should Consider Investing in Debt Instruments

 

These are the 3 major reasons why an investor regardless of his/ her risk appetite must consider investing in debt instruments

1. Low-Risk Instruments

Debt Instruments are independent of market fluctuations and hence, carry significantly lower risks. It helps you mitigate the risk of market fluctuation by cushioning your portfolio. 

2. Short-Term Maturity

There are debt instruments of varied durations, and hence, are perfect to meet short as well as long term financial goals with less risk involved. 

3. Risk-Adjusted Returns

Specific debt instruments like bonds, debt mutual funds, and debentures offer great risk-adjusted returns, and hence, they are preferred over other risky investment instruments offering similar returns. 

 

Apart from the above, there are specific debt instruments like debt mutual funds that offer you the flexibility to invest in small monthly installments via SIPs. 

Risks Involved

risk-involved-debt

 

The risk involved in the debt instruments range from less to high. While there are certain government bonds, G-Sec, Treasury bills which are the safer instruments, there are other debt instruments that carry credit risk, fraud risk, and liquidity risks. 

1. Credit Risk

Debt instrument refers to the risk of defaulting in repaying the investor’s money.

 

The level of risk will change depending on which type of debt instrument you invest your money in. For example, unsecured debentures will have high credit risk as they are unsecured. 

2. Liquidity Risk

It means the risk of not being able to withdraw the invested money while facing liquidity issues.

 

For example, while FDs can be broken prematurely by paying a penalty. However in case of corporate bonds, the investor needs to wait till maturity to get back the invested amount.

 

In case the investor wants to exit before that he/she will need to sell their bonds to a willing buyer and such a willing buyer may not be available at all points of time.

3. Fraud Risk

It relates to the risk of falsifying the entire investment and faking promise of repaying the money and the interest intentionally. 

 

However, the most significant risk of market fluctuation is avoided in debt instruments as they are independent of such movements.

 

Therefore, they are the safer investment option as compared to equity instruments.

 

 

Closing Thoughts

Ideally, your portfolio should combine debt and equity instruments to maintain a balanced financial profile. Which means, you portfolio should not be too exposed to risk and neither should it be too conservative.

 

Debt Instruments are definitely the way to go for a more wholesome financial profile.

 

Happy Winting!

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