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.
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.