Debt investors and how they actually make money
While most people are familiar with stocks and how they work, debt investments are a far less understood asset class.
But did you know that bonds can occasionally generate stock-like returns or even outperform them—with much less risk? In fact, many fund managers expect bonds to do just that in the coming years.
Bonds also serve as investment portfolio insurance (in financial lingo, “hedging”). They reduce an investor's overall risk by providing a steady stream of income.
Read on if you're looking for a way to generate income with reduced risk, especially in today's rising rates climate.
What debt investing is and how it earns money
Debt investing is when you loan money to companies or the government. These loans are called debt securities, and they can be bonds, notes, or other types of debt instruments.
In return, the company or government agrees to pay you interest payments over a set period of time, as well as the principal amount of the loan at a predetermined time in the future.
Interest payments derived from bonds provide a steady income stream, making them attractive for income-oriented investors, especially during periods of market volatility.
While stock investors need companies to grow to earn money, all bonds investors need are for the debtor not to go bankrupt. Think of it as investing in an issuer's creditworthiness.
Note that this applies only if you hold debt instruments to maturity—or in simple terms, until they expire and the debtor returns the principal.
If you were to trade them, their market prices fluctuate like those of stocks. The key driving force of the bond market prices are changes to interest rates.
Equity investing vs. debt investing
There are four main things that separate equity and debt investing
Equity investing is when you buy a company’s shares, entitling you to a portion of its profits. You become a part-owner with a stake in the company's success.
Debt investing does not entitle you to ownership—you're simply a lender making a profit on interest incurred.
Equity investing is more volatile because it relies on a company's success to turn a profit. Debt investing, on the other hand, offers guaranteed interest payments regardless of company performance.
But if not held to maturity, debt instruments are more prone to interest rate risk. When rates rise, typically the bond market value falls. And vice versa.
Stock prices go up and down, resulting in significant gains or losses. Debt income is generally more stable because it offers fixed interest payments and is less likely to experience fluctuating returns.
But if not held to maturity, the market value of a bond can fluctuate based on interest rates.
Debt investments have a fixed duration compared to stock investments because they have a so-called maturity date. Once the bond matures, the investor receives the total investment amount back.
Generally, bonds with longer maturities have higher interest rate risk.
Equity investments such as stocks do not have a fixed maturity date. Instead, a stock investor’s return depends on the performance of the company's stock over time.
Types of debt securities
The many types of debt investment opportunities cater to a diverse range of lenders' and investors' needs and preferences.
- Bonds: Common, long-term debt instruments issued by governments, municipalities, and corporations to finance public projects. They have fixed interest rates and specific loan repayment dates.
- Treasury Bills (T-bills): Short-term investments issued by the U.S. government. They are the safest types of investment since the U.S. government has never defaulted on its debt.
- Certificates of deposit (CDs): Savings products provided by banks and credit unions that come with a fixed interest rate and a holding period.
- Commercial paper: Another short-term investment, usually repaid within one year, that companies issue to finance short-term operations.
- Corporate bonds: Fixed-rate corporate bonds offer a steady and unchanging interest rate throughout the bond's duration. Conversely, floating-rate corporate bonds feature an interest rate periodically adjusted according to the market.
- High-yield bonds: Also called junk bonds, these are issued by companies with a low credit rating. They offer a higher interest rate but also carry a higher risk of default.
- Mortgage-backed securities (MBS): When you invest in an MBS, you buy a share of a pool of mortgages.
How individuals can invest in debt
Buy treasury bonds directly from the government
It's easy to purchase Treasury bonds directly from the U.S. government by visiting TreasuryDirect.gov. To start, create an account funded by your bank account or credit card. Once set up, you can buy a selection of Treasury bills, notes, and bonds.
Purchase mutual funds or exchange-traded funds (ETFs)
ETFs are corporate and government bonds traded on an exchange like stocks. When you buy an ETF, you invest in a basket of securities.
There are several exchanges that track government, corporate, and municipal bonds, such as:
- iShares Core U.S. Aggregate Bond ETF
- Vanguard Total Bond Market ETF
- BlackRock iShares iBoxx $ Investment Grade Corporate Bond ETF
To invest in ETFs, you need to open a brokerage account on the platform, or you can work with a traditional broker who will manage your investments for you.
Invest in crowdfunding platforms
Private debt platforms allow you to invest in loans that are not traded on public markets, which are risker but can provide higher yields.
Some focus on lending to small businesses, while others focus on lending to real estate developers.
Popular ones include:
- Fundraiser: A real estate crowdfunding platform.
- Brex: A financial technology that offers corporate debt investments.
- Prosper: A peer-to-peer lending platform that connects borrowers who need private loans with investors.
What is the best debt security for you?
As a potential debt investor, the following questions may help you narrow down the most suitable debt investment option:
- In terms of investment, are you looking for income, growth, or a combination?
- How much risk are you comfortable taking?
- How long do you plan to hold the investment?
As with any investment, you should always consult with a financial advisor. And remember, there is no one asset that will complete your financial portfolio.
A well-diversified portfolio is a carefully picked set of different asset classes adjusted to your personal goals and risk tolerance.
And while bonds may not hand you an Amazon-like moonshot, they can cushion your nest egg when other investments falter.