We keep hearing and reading about the terms Debt & Equity in all financial conversations. Most of us assume a meaning of our own understanding and end up in mixing the two categories of investment. While interacting with several friends I realized that this lack of clarity causes doubts while choosing from diverse options. This article aims at making the understanding of Debt Investments more meaningful.
What is Debt ?
Debt is a transaction in which someone borrows money from other person/agency who is willing to lend. Debt can be both a liability, or an asset, depending on which side of the transaction you are on. If you borrow, you undertake an obligation to pay interest as decided, and therefore it is a liability. If you lend, then you have the right to receive interest, and therefore it is an asset. In any economy there are always those who have more money in hand than their immediate needs. And there are others who have a shortfall. So those with some surplus are willing to provide their money to those in need. In return they expect some returns. When this return is in the form of a pre-decided periodic interest, the transaction is a Debt transaction.
What is Equity ?
Other form of transferring money from surplus to deficit areas is Equity. If you need money for some business purposes, then you can either borrow from individuals/institutions, or sell a share of business through Equity Shares. In the latter case, there is no promise to pay any pre-fixed periodic return. But there is an obligation to share profits, if any. The provider of money in the form of equity expects a share from profits which can be variable. He also runs the risk of losses wherein he might lose his entire equity capital. We shall discuss more about various aspects of equity in subsequent articles.
What is investing in Debt ?
Investing in Debt means being on the lender side of any Debt transaction. We can do this directly, or indirectly. When we give a loan to some known person at some fixed annual interest rate, it is the simplest and most direct form of debt investment. In older times, this was one of the most common business of many rich landlords. With development of banking facilities, most of us prefer to keep our money with banks either in savings account, or in Deposits. Both these instruments give us a declared annual interest (returns). The Banks in turn lend this money to those in need at a rate higher than what they are paying to you. The difference is their revenue.
We can also be appreciate that large borrowers need huge amount of loan. This is generally beyond the capability of individuals. Banks can facilitate such transactions because they have pooled lot of money from the individual savings account/deposit holders. Another indirect investment in Debt is through Mutual Funds. Wherein investors provide money to a particular scheme which loans it out to either the Government, or Corporate. They do this by buying bonds which are basically loan agreements.
Forms of Debt Investments
Having understood the basic concept of Debt, we can now identify the various common forms of Debt Instruments. The simplest of these are the savings account and the fixed deposits held with the bank. The Provident Funds, either with the employer, or the Public Provident Fund would also be categorized as Debt as the annual interest rates are known. NPS will be considered as Debt to the extent of share of subscription that has been earmarked for Government/Corporate Bonds. Companies also raise debt by issuing debentures. Mutual funds which invest in only Government/ Corporate Bonds of different forms are also categorized as Debt.
Many mutual funds are hybrid in nature, ie they invest part in Debt, and part in Equity. In such schemes only the portion of debt investment can be taken as Debt. Though overall it might be qualifying as Debt/Equity Scheme as per SEBI guidelines. Nowadays, one can also invest directly in govt/corporate bonds. With developments in technology, today there are also a plethora of digital lending platforms where both borrower and lender can transact.
Risks in Debt Investments
We have earlier discussed about Risk and Return in the article “Look Before You Leap- Are You measuring Risk before Investing ?” Debt investments scale lower in both risk and return. There are three major risks in Debt investments. One is the default risk, second is the interest rate risk, and third the re-investment risk.
Risk of Default means that the borrower refuses to pay back either the interest, or the principle, or both. The loan to government is considered risk free. The benchmark risk-free rate is taken from the 90 days Treasury Bills (interest provided by government on short term loan of 90 days). The accounts and deposits in banks are also considered reasonably safe along with associated insurance. The Provident Funds being managed by government are also safe. However, the risk starts increasing with the lending to the corporate side. The rating agencies like CRISIL carry out rating of various corporate bonds to enable investors in understanding associated risks. Though recently their job has also come under intense scrutiny. The investments in risky debt instruments are attracted by offering higher interest rates/returns.
The second risk is the Interest rate risk. The interest rates change based on the RBIs monetary policy decisions. If the rates rise then previous debt investments at lower rates tend to lose, and vice versa.
The third risk is the re-investment risk. After the tenure of lending is over, one needs to re-invest the amount at prevailing rates. These might be different from the rate of initial investment.
Returns from Debt Investments
The returns from debt investments which are risk free are generally less. These are more or less close to the inflation rates. The returns from deposits tend to increase with the tenures. This is because deposits give banks a larger window to loan out the amount. The returns from government schemes like provident funds etc. are fixed for a given duration, and variable otherwise. These are re-fixed at regular intervals based on the returns generated by the fund and resultant paying capacity. The returns from Debt Mutual Funds are variable depending on the underlying asset class. Which are Government or corporate bonds of various ratings, and the diverse proportions of different tenures of bonds. The range of returns from Debt investments would lie between the low return from savings account, to high returns from some well performing high risk corporate bond.
Conclusion
Debt assures reasonable safety as compared to equity and expectedly lower, but sustained returns. The proportion of debt investments and the diversifications within debt portfolio need to be planned in accordance with the overall financial plan, and near-term objectives. As a general rule, the money required for next five years for any purpose, should certainly be kept in debt investments only.