What Is a Debt Instrument? Definition, Structure, and Types

What Is a Debt Instrument?

A debt instrument is a financial tool that is used to raise capital. It is a documented, binding obligation between two parties in which one party lends funds to another, with the repayment method specified in a contract. Some debts are secured by collateral and most involve interest, a schedule for payments, and a time frame to maturity if it has a maturity date. Bonds are common types of debt instruments that governments and corporations use to raise capital.

Understanding Debt Instruments

Debt is typically a top choice for raising capital because it comes with a defined schedule for repayment. This comes with less risk for the lender and borrower, which allows for lower interest payments.

Any type of instrument primarily classified as debt can be considered a debt instrument. Generally, the instruments used are some form of term debt, credit, or other revolving debt—credit instruments that you can continually draw on—with repayment conditions defined in a contract. Credit cards, lines of credit, loans, and bonds can all be considered debt instruments.

A debt instrument typically focuses on debt capital raised by governments and private or public companies. The issuance markets for these entities vary substantially by the type of debt instrument.

Credit cards and lines of credit can be used to obtain capital. These revolving debt lines usually have a simple structure and only one lender. They are also not typically associated with a primary or secondary market for securitization. More-complex debt instruments involve advanced contract structuring, multiple lenders, and investors usually investing through an organized marketplace.

Special Considerations

Debt securities are a more complex debt instrument involving greater structuring. If a business structures its debt to obtain capital from multiple lenders or investors through an organized marketplace, it is usually characterized as a debt security instrument. These are complex, as they are structured for issuance to multiple investors.

Fixed-Income Debt Instruments

U.S. Treasury Bonds

Treasury bonds come in many forms denoted across a yield curve. The U.S. Treasury issues three types of debt security instruments, bills, notes, and bonds:

• Treasury bills have maturities ranging from a few days to 52 weeks.
• Treasury notes are issued with two-year, three-year, five-year, seven-year, and 10-year maturities.
• Treasury bonds have 20-year or 30-year maturities.

Each of these offerings is a debt security instrument the U.S. government offers to the public to raise capital to fund the government.

Municipal Bonds

Municipal bonds are debt securities issued by state and local governments to fund infrastructure projects. Municipal bond security investors are primarily institutional investors, such as mutual funds. They are available in taxable and tax-exempt formats and are generally considered to be low-risk investments.

Corporate Bonds

Corporate bonds are a type of debt security instrument used to raise capital from the investing public. Corporate bonds are structured with different maturities, which influence their interest rate. They have an active secondary market that retail and institutional investors can use.

Mutual funds are usually some of the most prominent corporate bond investors. However, retail investors with a brokerage account may also be able to invest in corporate bonds through their broker.

Alternatively Structured Debt Security Products

There are also alternatively structured debt security products in the market. These are primarily used as debt security instruments by financial institutions. They include a bundle of assets issued as debt security, such as a collateralized debt obligation (CDO). Financial institutions and agencies may choose to bundle products from their balance sheet, such as debt, into a single security. This is then used to raise capital while segregating the assets.

Other Types of Debt Securities

Credit facilities are also considered debt securities. Issued by banks, financial institutions, and other lenders, these products allow borrowers to raise capital for different reasons, including making everyday purchases, buying a house or car, or making repairs to their homes. In exchange for the capital, the borrower agrees to repay the lender the principal balance plus interest.

The following are some of the most common types of credit facilities:

• Mortgages
• Credit cards
• Personal and commercial loans
• Lines of credit (LOCs)
  

The Bottom Line

Debt instruments are any form of debt used to raise capital for businesses and governments. There are many types of debt instruments, but the most common are credit products, bonds, or loans. Each comes with different repayment conditions, generally described in a contract.