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A debt instrument is a contractual or written assurance to repay a debt. A

debt instrument can be a promisory note, a bill of exchange, a bond or other
such instrument. A debt instrument may also be referred to as an
instrument of indebedness. In most cases a debt instrument can be sold,
traded, or otherwise used as a form of currency or barter, with the debt
owed to the debt instrument's current holder. A debt instrument backed by a
government agency -- such as a U.S. Treasury Bond -- or a highly-rated
corporate bond with a fixed dollar payment may be defined as an asset.
Defaulting on a debt instrument may result in the loss of the pledged
collateral, or in a reduction of the credit rating of the entity which issued the
debt instrument.

A debt instrument is any type of documented financial obligation that describes a

debt that is assumed by the issuer of the document. Essentially, the debt instrument
commits the issuer to reimburse the debt according to terms agreed upon between
the buyer and the seller. Some examples of debt instruments include corporate and
municipal bonds, Commercial Papers, Treasury Bills, and Certificates of Deposit.

One of the benefits of the debt instrument is that the document makes it possible to
effectively transfer the ownership of debt. It is common for creditors to trade debt
obligations as a means of generating revenue and keeping liquidity at a higher rate.
The end result is that it is possible for lenders to make use of the funds collected
from investors while still protecting those investments and be in a position to make
interest payments as well as eventually repay the principle of the debt as well.

A Certificate of Deposit is a common debt instrument that is purchased by an

investor. Considered a low risk investment, CDs allow the investor to make a
modest return on the balance in the account over a period of time. While the funds
are in the possession of the bank, the worth of the funds on deposit is used for
trading debt and allowing the bank to remain liquid. As a result, the bank can make
use of those funds to grow and still provide full coverage and a wide range of
services to bank customers.

In like manner, bonds are also an example of a debt instrument that earns a modest
but reliable return for the buyer. The bond issue may be structured to pay off the
face value or amount of purchase plus interest at some agreed upon future date.
Some bonds also issue periodic interest payments during the life of the bond.
During this period, the buyer is earning a return and has full assurance of
eventually recouping the initial investment as well. In the interim, the issuer of the
bond is free to trade the debt in order to maximize the ability to make use of the
debt instrument.

A commercial paper is a example of the debt instrument. Commercial papers are

documents such as promissory notes that are intended to serve as documentation
for short-term loans. The commercial paper helps to define the nature of the loan
and may include information such as a date for the note to come due. Anyone
holding a promissory note can trade the active note to another entity without
impacting the commitment of the recipient of the note to repay the outstanding
debt.

There are other forms of the debt instrument that are in common use today.
Mortgages and leases are also considered to be debt instruments. Essentially, if an
existing debt can be traded between one or more entities, it meets the basic
definition of a debt instrument.

Financial instruments can be categorized by form depending on whether they are

cash instruments or derivative instruments:

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Alternatively, financial instruments can be categorized by "asset class" depending

on whether they are equity based (reflecting ownership of the issuing entity) or
debt based (reflecting a loan the investor has made to the issuing entity). If it is
debt, it can be further categorized into short term (less than one year) or long term.

Equity security
An instrument that signifies an ownership position (called equity) in a corporation,
and represents a claim on its proportional share in the corporation's assets and
profits. Ownership in the company is determined by the number of shares a person
owns divided by the total number of shares outstanding. For example, if a company
has 1000 shares of stock outstanding and a person owns 50 of them, then he/she
owns 5% of the company. Most stock also provides voting rights, which give
shareholders a proportional vote in certain corporate decisions. Only a certain type
of company called a corporation has stock; other types of companies such as sole
proprietorships and limited partnerships do not issue stock. also called equity or
stock or corporate stock.

Preferred shares
Capital stock which provides a specific dividend that is paid before any dividends
are paid to common stock holders, and which takes precedence over common stock
in the event of a liquidation. Like common stock, preferred shares represent partial
ownership in a company, although preferred stock shareholders do not enjoy any of
the voting rights of common stockholders. Also unlike common stock, a preferred
share pays a fixed dividend that does not fluctuate, although the company does not
have to pay this dividend if it lacks the financial ability to do so. The main benefit
to owning preferred share is that the investor has a greater claim on the company's
assets than common stockholders. Preferred shareholders always receive their
dividends first and, in the event the company goes bankrupt, preferred shareholders
are paid off before common stockholders. In general, there are four different types
of preferred stock: cumulative preferred, non-cumulative, participating, and
convertible.

Government securities

Bonds, notes, and other debt instruments sold by a government to finance its
borrowings. These are generally long-term securities with the highest market
ratings.

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Bonds refer to debt instruments bearing interest on maturity. In simple terms,
organizations may borrow funds by issuing debt securities named bonds, having a
fixed maturity period (more than one year) and pay a specified rate of interest
(coupon rate) on the principal amount to the holders.
Bonds have a maturity period of more than one year which differentiates it from
other debt securities like commercial papers, treasury bills and other money market
instruments.

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Zero Coupon Bonds are issued at a discount to their face value and at the time of
maturity, the principal/face value is repaid to the holders. No interest (coupon) is
paid to the holders and hence, there are no cash inflows in zero coupon bonds. The
difference between issue price (discounted price) and redeemable price (face value)
itself acts as interest to holders. The issue price of Zero Coupon Bonds is inversely
related to their maturity period, i.e. longer the maturity period lesser would be the
issue price and vice-versa. These types of bonds are also known as Deep Discount
Bonds.

 

 


Treasury strips are more popular in the United States and not yet available in India.
Also known as Separate Trading of Registered Interest and Principal Securities,
government dealer firms in the United States buy coupon paying treasury bonds
and use these cash flows to further create zero coupon bonds. Dealer firms then sell
these zero coupon bonds, each one having a different maturity period, in the
secondary market.




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In some bonds, fixed coupon rate to be provided to the holders is not specified.
Instead, the coupon rate keeps fluctuating from time to time, with reference to a
benchmark rate. Such types of bonds are referred to as Floating Rate Bonds.
For better understanding let us consider an example of one such bond from IDBI in
1997. The maturity period of this floating rate bond from IDBI was 5 years. The
coupon for this bond used to be reset half-yearly on a 50 basis point mark-up, with
reference to the 10 year yield on Central Government securities (as the
benchmark). This means that if the benchmark rate was set at ³X´ %, then coupon
for IDBI¶s floating rate bond was set at ³(X + 0.50)´ %.

Coupon rate in some of these bonds also have floors and caps. For example, this
feature was present in the same case of IDBI¶s floating rate bond wherein there
was a floor of 13.50% (which ensured that bond holders received a minimum of
13.50% irrespective of the benchmark rate). On the other hand, a cap (or a ceiling)
feature signifies the maximum coupon that the bonds issuer will pay (irrespective
of the benchmark rate). These bonds are also known as Range Notes.
More frequently used in the housing loan markets where coupon rates are reset at
longer time intervals (after one year or more), these are well known as Variable
Rate Bonds and Adjustable Rate Bonds. Coupon rates of some bonds may even
move in an opposite direction to benchmark rates. These bonds are known as
Inverse Floaters and are common in developed markets.