What is debt?

Posted by Mehul Kothari | Published on 14 Feb 2019
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What is debt?

Every company needs funds to grow its business. It can raise these through two kinds of instruments – equity and debt.

What is debt?

Debt instruments are issued by companies and the government to borrow funds from investors. In addition to financing growth initiatives, issuers use these funds to meet unexpected cash requirements or generally bridge the gap between income and expenses. Debt is generally raised for a very specific purpose that is mentioned in the term of agreement, called the bond covenant. 

There are several types of debt instruments. They are classified into short-term and long-term based on their maturity.

- Short-term debt instruments

Short-term or money market instruments have a maturity of up to one year. They include Treasury Bills (T-bills), Commercial Papers (CPs), Certificate of Deposits (CDs), Repurchase Agreements (Repo), and Banker's Acceptance.
T-bills and CPs are among the most common money market instruments. T-bills are issued by the central government for maturities of three-month, six-month, and one-year. CPs are issued by companies and have a maturity ranging from one to 270 days. 

- Return on Zero-coupon bonds

T-bills and CPs are called Zero-coupon instruments because neither pays periodic interest (called coupon). Instead, they are issued at a discount and redeemed at par. For example, a company may issue CPs worth Rs.100 each (called par value) at Rs.96 (i.e. at a discount of Rs.4). If you invest in it, you will receive Rs.100 each on maturity. The difference of Rs.4 is your return.

- Long-term debt instruments

This includes bonds issued by companies and the government for a term of above one year. They generally pay a periodic coupon and return your original investment at the end of the term. 

The coupon rate can be fixed (such as 6%, 8%, 11%...) or floating. The coupon for a floating rate bond depends on another rate and is calculated using a fixed formula every time. For example, a floating-rate bond linked to inflation is called an inflation-linked bond. Its coupon is calculated using an inflation-based formula like [inflation rate + x%].


Why companies raise debt?

You must be wondering why companies raise debt when they can raise money through equity. Simple: equity and debt are different products with unique characteristics. The sum of funds raised through these is called the company’s capital. The objective is to weigh the features of these products and decide the company’s ideal capital mix or, formally, capital structure.

Debt is a cheaper source of funds than equity because the coupon rate is always lower than what the company pays equity holders. However, unlike equity dividends, the company is legally bound to pay the coupon in every period. Equity dividends can be increased, decreased or even cancelled at the company’s will.

Also, promoters have to part with their shares whenever a company raises equity. This reduces their say in the business and they are not always willing to do this.


Risks of investing in bonds

Bonds are considered low-risk investments because they pay a regular coupon and give investors a legal claim on the company’s assets in case their dues are not paid. Although safer than stocks and other instruments, bonds are not completely risk-free. The ability and willingness of the borrower to pay you are the greatest sources of risk for bond investors.

Increasing interest rates is another major source of risk because bonds trade on the exchange like stocks. When interest rates increase, new bonds with the same features pay a higher coupon. This reduces their value on the exchange. Let’s look at an example.

Suppose you own a bond that pays 9% coupon. When interest rates go up, new bonds with the same characteristics will pay a higher coupon, say 10%. Investors that are holding the same bond as you will sell it and invest in the new bonds. But they can only sell at a lower price because other investors would rather buy the new higher-paying bond for the same price. So, your bond’s price will fall, resulting in a loss. 


Risk premium

The government is the safest borrower because it is the most likely to meet its bond obligations. This is why government bonds are called risk-free bonds. All other bonds are considered riskier. However, to compensate investors for the risk they take by investing in their bonds, other bond issuers pay a higher coupon than government bonds. This extra coupon is called the risk premium.


To sum up

Equity and debt are just as important to your portfolio as to a company’s capital structure. Equity maximizes returns and debt minimizes risk. Your investment strategy should be to optimally allocate funds to debt and equity based on your investment objectives.

If returns are more important to you, invest more in equity. But be prepared to incur losses along the way. If security is more important to you, invest more in debt. But don’t expect supernormal returns.

 

 

 

Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.

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Tips for Choosing Investment Options in India

Posted by Mehul Kothari | Published on 14 Feb 2019

As long as you are in college, the common advice you get is: study well. But once you get a job and you start earning, the advice you get changes. Your family members advice you to start saving. Saving is good but it is more important to invest.But with so many investment options available, it is difficult to zero in on one investment option. Also, what is the right time to invest in a particular avenue?Well, the answer depends on various factors, one of them being the goals you set in your life. However, your life goals may vary. You may have a set of goals you wish to achieve in the next two, five, 10 or even 20 years. Based on the time limit, your investment goals can be divided into three categories:a) Short-term goalsb) Medium-term goalsc) Long-term goalsInvestment in short-term goalsA short-term financial goal can be something you wish to achieve in the next week or in the next year. Typically, the time span for short term goals is anywhere between one week and two years. For short-term goals, it is good to earn a steady rate of return. But it is also very important to ensure you don’t lose your investment capital. That’s why investment in equities can be a bit risky as they are generally volatile in the short-term. That’s why investment in debt is quite popular among investors when the time limit is less.Investment options for medium-term goalsMedium-term goals can range anywhere from 3 to 5 years. For example, you may want to buy a second car in the next three years. For goals like this, it is best to invest in a healthy mix of debt and equity. It is good to invest in balanced fund to get good returns and to protect capital from exposure. Investment in ELSS funds is also a good option. The best part about ELSS investments is that in addition to good returns, you can also avail tax benefits.Investment options for long-term goalsLife is uncertain and it is always good to plan for the future. That’s why planning for a retirement that is 30 years away is not uncommon among investors. Buying a house or funding your kid’s college education are some of the common long-term financial goals. These goals may be 10-15 years away but it is important to start investing today.It is best to invest in equity funds, ULIPs or stocks for long-term financial goals. Investing in these avenues helps investors get great returns. For example, equity mutual funds offer anywhere between 10-15% per annum and stocks have the potential to offer much higher returns. Investment in stocks is generally considered risky. However, the long time period helps investors to digest risks down the line. Investment in PPF funds and NPS are viable options if saving for retirement and capital preservation are your biggest goals.ConclusionWith so many investment options available, it can get confusing. So, instead of asking which investment to choose, the better question is: what is the right time to choose this investment. So, based on the time period of your investment goals and your risk appetite, you can make your investment decision.   Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.

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Factors Affecting Investment Decisions

Posted by Mehul Kothari | Published on 14 Feb 2019

Investment choices vary from investor to investor depending on their goals, risk tolerance and individual personality. But, there are certain common factors that affect everyone’s investment decisions. Whether you make investment decisions on your own or rely on professional help, knowing the factors that affect your investment decision is essential to maximize your portfolio return.Factors affecting investment decisions are:▪ Net worthYour family’s wealth or net worth plays a major role in investment decision-making. For example, two friends with similar salaries can have completely different family background and thus completely different investment patterns. Someone from a wealthy family would easily be able to take exposure in equity without having the fear of losing a part of the portfolio while another person with limited means might be more conservative in nature. Tip: So, your family’s net worth needs to be considered while taking investment decisions. ▪ Risk appetite If you are one of those who lose their sleep if the investment portfolio goes below your invested amount even for a day, then equity is not your forte. Your willingness to take risk affects your investment choices. For example, if you are comfortable with daily volatility of the market, you can consider to build an aggressive portfolio. Tip: You can slowly start equity investments with MIPs, balanced funds, etc. before plunging into equity-oriented options like equity mutual funds, stocks and unit-linked insurance plans (ULIPs). ▪ Time horizon A longer time horizon allows you the opportunity to invest in relatively riskier options like stock. That’s because the volatility of stocks usually flatten over time. However, if you have a shorter time span, investments with stability and guaranteed return are the probable choices for you. Tip: The earlier you start, the better it is since the power of compounding helps in building your investment portfolio. ▪ Investment need Once the financial goals are known, the primary reason for investment is evident. That helps in making investment decisions easily. This is because the amount of money needed for the specific goal and timelines would be specified, making it easier to plan. Tip: Your needs have to be separated from wants. Once the investment need is known and penned, it becomes easier to plan and stick to it as well. ▪ Return expectations Depending on your return expectation, you can choose the right investment avenue to meet your desired goal. Each investment has its associated risk and expected return and being an investor, you would know that there is a trade-off between risk and return, i.e. higher the expected return, higher would be the associated risk. Tip: However, opting for high-risk investments might not be most desirable in your investment journey as the converse is not always true. So, investment is a game of choosing your risk and then achieving the return on investment and not the other way round! ▪ Investor knowledge and experienceAn experienced investor usually takes faster and smoother investment decisions without too much time. Thus, an Investor’s experience plays a role in decision making. It’s also good to seek help of expert advisers to smart decisions. Tip: It takes time for investors to gain investment experience which cannot be expedited under any circumstance. So, start slow, enjoy the investment experience before taking any drastic step!ConclusionThere are lot more factors that goes into making investment decisions and it depends on your personal profile, family history, number of dependants, loans, etc. Considering the various factors while making investment decisions can help you build a solid investment portfolio that best suits your needs and temperament.   Disclaimer: Investment in securities market / Mutual Funds are subject to market risks, read all the related documents carefully before investing.

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