Debt investment is the investment in debt obligations. Like a mortgage loan. Debt investors normally earn interest until the time the debt is fully repaid. These investments sometimes provide an option to convert to an equity position.
Debt investment means lending money to a company or a project sponsor by purchasing a large quantity of debt with the expectation that the debt will be repaid along with interest accrued on it. Generally debt investment is done by financing companies, banks and other licensed lenders.
This type of investment is secured through a legal document that obligates the borrower to pay back the money at fixed intervals. Debt investment can be both secured and unsecured. In secured debt investment, the borrower uses an asset to be the collateral. In case the borrower is unable to repay the amount, they forfeit their asset. In unsecured debt investment, there is no collateral and the debt is backed based solely on the creditworthiness of the borrower.
Debt investment offers the investor with a steady stream of income through regular interest payments. Some examples of debt investments include tax liens, corporate bonds, government bonds, mortgage-backed securities and short-term commercial paper.
The easiest way to differentiate between equity and debt investments is to remember that in an equity investment, the investor becomes a shareholder of the company or property. It means that the investor is directly buying the shares of the company and is expecting to earn through dividends. In this case, the investors can earn high returns if their share prices go up in the market.
Contrary to this, a debt investor would still get fixed returns (that they agreed on) even if the company continues to grow exponentially. This is known as capped returns. There are many pros and cons to both types of investments, hence, investors must do well research before choosing an investment option.
In any type of investment, it is important to make an informed decision. In case of debt investment, there are several factors that investors should consider before investing. Some of these are:
In addition to receiving regular interest, another big advantage is that the investor agrees to an asset as collateral. This collateral can be used by the investor as per their discretion if the borrower fails to repay the borrowed amount. It is also a more secured investment than equity as the investor has a guaranteed backup plan in case the borrower defaults on the loan. Another advantage is that it provides the investor with a predictable steady income. Whether the interest is paid monthly or quarterly, the investor will know the frequency and the amount they will receive and hence, they can manage their expenses accordingly.
Perhaps the biggest disadvantage of debt investment, as compared to equity investment, is that the returns are capped. The return is fixed which means if the company ends up becoming highly successful, the investor would still get a fixed return while equity investors can earn big bucks through the shares of the company that they hold.
A debt investor makes money through the interest that he receives from the borrower. This is the only way that he generates income through this type of investment. In addition to receiving the principal amount on maturity of the bond, the interest accrued is the source of income for the investor.
Debt investments are considered as assets because they have an economic value. In a debt investment, the investor lends money to a borrower and agrees to get interest on the money he lent in addition to the principal amount that will be repaid at the end of the bond. Hence, debt investments make money for the investor and have an economic value which is why they are considered as assets.
Debt investment generates a good source of income through the interest amount. In addition to that, investors also have an asset of the borrower under their control as investors have the right to sell the asset if the need arises. Thus, debt investment is a type of asset for the investor.
Having said that, it is important to consider all the factors that impact the investment deal. Hence, investors should gather all the information before they move ahead with the investment.