What is a Debt Instrument?
A debt instrument is essentially a loan made by an investor to a borrower. The borrower can be a corporation, a government, or a municipality. In exchange for the loan, the borrower agrees to pay the investor interest over a specified period and to repay the principal (the original loan amount) at a future date, known as the maturity date. These instruments are also known as fixed-income securities.
Common Types of Debt Instruments
- Bonds: The most common type of debt instrument. When you buy a bond, you are lending money to the issuer. Bonds are issued by corporations (corporate bonds) and governments (government bonds, such as U.S. Treasury bonds).
- Treasury Bills (T-Bills): Short-term government securities with maturities of one year or less. They are sold at a discount to their face value and do not pay periodic interest.
- Certificates of Deposit (CDs): A savings certificate with a fixed maturity date and specified fixed interest rate, issued by banks.
The Role of Credit Ratings
The risk that a borrower will not be able to make their promised payments is known as credit risk. Credit rating agencies like Moody's and Standard & Poor's assess the creditworthiness of bond issuers. Bonds with higher credit ratings (e.g., AAA) are considered safer and therefore offer lower interest rates, while bonds with lower ratings (often called "junk bonds") must offer higher interest rates to compensate investors for the additional risk.
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