Debt Instrument: Definition, Overview & Example

KEY TAKEAWAYS

• Any instrument that’s classified as debt will often get considered as a debt instrument
• There is flexibility for the debt instruments used by businesses and they can choose how to structure them.
• A debt instrument is a type of financial tool that can be used to help raise capital or generate investment income.

What Is a Debt Instrument? 

A debt instrument is a type of financial tool that can get used to help raise capital. Basically, it’s a fixed-income asset where a debtor provides interest and principal payments to a lender. The debt instrument used is a documented and binding obligation that gives funds to an entity, which will pay back the funds based on the terms of a contract. 

Usually, the debt instrument contract will have various provisions that will include things such as the rate of interest, collateral involved, the timeframe to maturity, and the schedule for interest payments.

Types & Examples of Debt Instruments 

There can be a broad range of debt instruments across the financial industry. Banks and other financial institutions will issue these to consumers, and they’re often referred to as credit facilities. 

Consumers have several reasons for applying for credit, such as paying off debts, purchasing a car, or making larger purchases they will pay off at a later date. 

Here are some of the most common types of debt instruments.

Bonds 

A government or business is able to issue a bond. An investor would pay the issuer of the bond the market value. In return, they would provide guaranteed loan repayment and the promise to pay scheduled coupon payments. 

Scheduled coupon payments are expressed as a percentage of the face value of the bond and it’s the annual rate of interest the bond would pay. 

Debentures 

Debentures are often used to help fund projects by raising short-term capital. With this type of debt instrument, it’s backed by the trustworthiness of the issuer and their credit. Like bonds, debentures are popular with investors since they have guaranteed fixed rates of income. 

Fixed-Income Assets 

Fixed-income assets are offered by corporations and government entities to investors as investment securities. An investor would purchase security for the full amount of the asset. 

Then, they would receive either interest or dividend payments in return until the debt instrument reaches maturity. Once this happens, the issuer of the debt would pay the investor the full principal amount. 

Mortgages 

Mortgages are a type of instrument that are used to finance real estate purchases, such as commercial property, a home, or land. The mortgage gets amortized over time which lets the borrower make payments until it is paid off in full. 

The lender of the mortgage is also going to receive interest in return. As well, the risk of default is minimized since the real estate purchase itself is used as collateral. 

Loans

Loans can be used for a variety of reasons and they can be obtained from a financial institution. When you take out a loan, you receive a sum of money from the lender with the agreement to repay the amount over a period of time. There will also be a predetermined amount of interest that will get added to each payment. 

Credit Cards 

When you apply for a credit card, you receive a credit limit that you have access to over time. You’re able to continue to use a credit card as long as you make any required monthly payments, and there are two payment options. 

They can either be made in full each month as a lump sum payment to avoid any interest charges or by making the minimum monthly payment. If the minimum monthly payment is made, the remaining balance will get carried into the next month with interest added. 

Credit score and credit history are two factors that are taken into account by a credit agency when you apply for a credit card. 

Lines of Credit (LOC)

Lines of credit give you access to a credit limit that’s based on a few things. Your credit score and the relationship you have with the bank are considered and the limit is revolving. This means that you can draw on it as long as you make the payments. 

Similar to other credit facilities, there’s a principal amount and interest with lines of credit. As well, they can be secured or unsecured, but this is based on the specific requirements of the borrower and the financial institution. There will also be a payment schedule to repay the remaining loan amount. 

Advantages & Disadvantages of Debt Security Instruments 

Debt can be a good choice to help raise capital since it comes with a defined schedule for repayment. With this also comes lower risk and ultimately lower interest payments. But within debt instruments, there are also debt securities. 

These include more in-depth structuring and can be more complex compared to regular debt instruments. Debt securities often get used when there’s a need to structure debt or obtain capital from more than one lender or investor. 

Essentially, debt security instruments are much more advanced and complex debt instruments that are issued to multiple investors. The most common debt security instruments include U.S. Treasuries, municipal bonds, and corporate bonds. Corporate bond investors will look to this type of debt security as a common debt instrument.

Summary

Debt instruments are used as a financial tool to help raise capital for any number of reasons. It could be as an investment, to purchase a new car, or to make a larger purchase and pay it off at a later date. Usually, they come in the form of fixed-income assets, such as debentures or bonds. 

Debt instruments are also issued by financial institutions in the form of credit facilities. But no matter how the debt instrument is issued, there is always a requirement to repay the principal balance to the lender by a certain date, including interest. 

Some of the more advanced debt instruments can be used for debt financing or as short-term debt securities. And they can be used by individuals, a business entity, a government entity, or an institutional entity.