Potential Benefits and Risks of Debt Investments

Key takeaways

• Fixed income securities are typically less risky than equity, but offer lower upside.

• The asset class offers different opportunities, depending on the level of risk an investor is comfortable with. 

• Yieldstreet provides access to fixed income instruments that are usually not available to retail investors.

Fixed income securities can offer a relatively safer cash flow. The Federal Government, corporations, municipalities, and states issue these securities as a tool to raise funds, whether it is for the general purpose of financing themselves or for specific projects.  An investor purchasing a bond is lending money to the issuer in exchange for the repayment of the principal plus a little extra – the interest payment – which can be received in periodic installments or as a bullet payment at the end of the life of the security.   

While debt is intuitively less risky than equity – a company will have to pay its debts before being able to compensate its shareholders – certain debt instruments can have a higher risk profile than publicly traded stocks.

Below are some of the potential benefits and risks of debt investments.

Debt versus equity

A bondholder typically acquires the right to be paid back a lump sum – usually multiples of 100 – plus an interest payment that is a percentage of the bond value. The payment – or payments – happen at predetermined intervals, usually yearly or bi-yearly. A failed payment can lead to a “default,” which has different meanings depending on the issuer.  

An equity investor holds a piece (“share”) of the investee company and has the right to a share of the company’s profits if they are distributed among shareholders (“dividend payments”). He also has the right to influence the company’s decisions together with other shareholders, although in practice, large public companies will have a controlling party and small, minority shareholders are likely to have limited influence. Needless to say, any increase in value of the company is likely to translate into an increase in share value that is beneficial for the equity investor.   

Intuitively, if a company is restructured, its assets are sold, and bondholders (debt investors) have the right to be repaid first. The remaining funds will then be distributed to shareholders (equity investors). Thus, a debt investment is typically considered less risky, but has lower upside potential. Meanwhile, an equity investment entails more risk as well as the possibility of greater returns. 

Examples of debt investments

While we’ve touched upon bonds as a form of fixed income investment, there are other forms of instruments to consider. Let’s look at all of them in detail.

Bonds, as we mentioned above, are issued when an entity needs to raise capital. Investors pay the market value of the bond to acquire it, and can usually force a default if they are not paid what they are promised. Bonds offer a “coupon” – a fixed percentage of the “par” price, which is a multiple of 100 dollars. The coupon is NOT equal to the interest payment, which is calculated by dividing the coupon by the market price of the bond. As an example, take a bond with a nominal, par value of a bond is 100, and with a 5-dollar coupon, If the market value of that bond falls to 90 (for example, because the issuing company is not performing well), the interest payment will be equal to 5/90, or 5.5%.

1. U.S. Government Treasuries and Agency Bonds are issued and backed by the government of the United States or one of its agencies. US Treasury bonds can be included in the broader category of “sovereign debt,” which defines all debt issued by sovereign governments, but is usually considered one of the safest and most liquid globally.  

2. Investment Grade Corporate Bonds are issued by a corporation and are rated BBB-/Baa3 or better by one of the major bond rating agencies: Moody’s Investors Service, Standard & Poor’s Global Ratings, or Fitch Ratings. The higher the rating, the lower the default risk.

3. Municipal Bonds, issued by a state, municipality, or county, are used to finance capital expenditures such as the construction of highways, bridges, sewer systems and schools. One distinct advantage of bonds in this category is that their returns are tax-free for investors. 

4. Debentures are “unsecured” bonds –  that is, bonds that are not backed by assets and are thus considered less senior – offering a fixed rate of return that is normally higher than bonds issued by the same company. They are sometimes referred to as “revenue bonds” because repayment typically comes from revenues generated by the project they were used to underwrite.

Issuers can either make an installment payment, or pay the entire promised amount when the first payment comes due, depending upon the terms of the agreement. In the event of a default, bondholders are paid first, then debenture holders and common shareholders — if any funds remain.

Convertible debentures can be exchanged for equity shares in a company after a certain amount of time has passed, which may increase their appeal among investors.  

Loan investments, such as peer-to-peer lending have the potential to generate higher yields, but they also have a higher risk profile. They have been institutionalized by online platforms that make it possible for investors to provide loans directly to individuals.

Investors can fund entire loans or take a position in multiple ones. The latter approach is typically recommended in order to achieve a degree of diversification. Borrowers do have to undergo a certain level of scrutiny, but this does not completely eliminate risk, especially the one generated by external market forces.

Potential Benefits and Risks of Debt Investing

The pros and cons of debt investing vary according to debt type. 

Bonds have the potential to provide fixed returns and are typically evaluated according to the issuer’s repayment capacity – as well as market condition, seniority –  which makes it easier to identify their risk profile. They also offer higher returns than traditional savings accounts — assuming liquidity is not required in the short term. Certain types of bonds – such as municipal bonds – can provide tax-free income. 

Their upside, however, is typically lower than that of equity investments. Limited liquidity can be an issue for certain more exotic bonds, while companies have the potential to default, which can trigger complex and expensive legal procedures. With the exception of inflation-linked bonds, this type of security is also sensitive to inflation, which can erode the present value of future fixed payments.

Debentures pay a regular interest rate that is usually higher than the one offered by secured bond issues. Convertible debentures can be turned into equity investments after a pre-defined period, at the holder’s convenience.

Should the issuer default, however, debenture holders will be paid before people holding common stock, but after more senior bondholders^[1].And just like bonds, debentures can be a problem in a market environment in which interest rates or inflation are rising. There are no assets serving as “collateral,” so you must vet the issuer more carefully.

Peer-to-peer loan investments have a low barrier to entry, provide monthly income and deliver higher yields than many other debt investments. You’ll have specific control over where your investment capital goes, which makes diversification easier to accomplish. Returns are also IRA friendly, which can have certain tax advantages. 

However, you are facing the risk of one or multiple defaults, and the nature of these investments makes them rather illiquid as well. Capital depletion is another concern. Principal and interest are repaid simultaneously, so you must be careful to separate principal payments out for reinvestment. 

Is debt investment right for you?

Diversification is a key feature of a resilient portfolio. Debt investment offers exposure to many different types of securities, which can help differentiate sources of returns.

Yieldstreet offers a wide variety of opportunities to earn passive income ,with investments as small as USD 500. Opportunities exist in classes that have been known to generate returns for decades but have typically been closed off to retail investors. These include art finance, real estate, commercial finance and legal finance. 

Many of these investments are backed by collateral, which can provide some degree of protection for your capital. You can also take advantage of short-duration opportunities, ranging from six months to five years.

_{1. For more information on the hierarchy of creditors, see https://www.investopedia.com/ask/answers/09/corporate-liquidation-unpaid-taxes-wages.asp#:~:text=If%20a%20company%20goes%20into,Stockholders%20are%20paid%20last.}