Investing Basics: Equity vs Debt
Caution – I am not an expert in finance or investment. Merely an enthusiast who enjoys learning.
This article should not be construed as investment advice. Writing this helps me keep all the terms straight.
Investment terminology can be confusing. Let’s explore the difference between equity and debt investments.
First though, let’s define an asset. An asset is anything that holds value. A physical asset can include land, a house, diamonds, original Beatles records, livestock, etc. Physical assets are tangible, and usually have inherent value.
A financial asset typically has contractual value, and not physical value. The contract may provide ownership of something, or grant rights to future payments of some sort. Financial assets include cash, bank deposit accounts, certificates of deposits (CDs), and also securities.
A financial security describes something that holds monetary value and can be traded between parties. Trades typically occur on a public or open market.
Not all financial assets are securities. A bank deposit account cannot be traded. Money (or in tangible form, currency) is used to exchange assets such as securities, but is not considered a security itself.
Most commonly, securities fall under two categories:
- Equity – where you invest in the value of an entity, by taking a part ownership stake
- Debt – where you loan money to an entity, in return for interest payments
The ‘entity’ can be a business or even a government. Why do such institutions offer equity or debt securities to investors? To raise money! Corporations may offer equity to fund new projects, product lines, or similar innovations to grow their business. Governments may issue debt to pay for infrastructure projects or social programs.
When an institution offers equity, they cede part ownership to the investor. Investors may get voting rights at the institution, and can influence business direction. Raising money through equity is typically more complicated and expensive for a company.
When an institution issues debt, no ownership is ceded. Instead, the institution enters a contractual obligation to pay interest on the debt, and to repay the debt in full at a future date. Raising money through debt is generally more straightforward than offering equity.
Let’s explore equity and debt securities in more detail.
More on Equity
A common form of equity investment is owning stock in a company. A share of stock represents some percentage of ownership of a company, depending on the total number of shares issued.
For example, if a company issues 10,000 shares, and you purchase 100 of those shares, you then own 1% of that company. In reality, most companies issue millions of shares. The average investor will own only the tiniest fraction of a company.
A company may be private or public. Private companies are owned by executives or private investors. Stock in a private company is not usually available to the average investor. A public company’s stock is traded on one of several public stock exchanges (such as the Nasdaq or New York Stock Exchange), and available for anyone to invest in.
How do investors make money off an equity? Generally two ways:
- Dividends – a portion of profits paid out periodically to all investors
- Appreciation – an increase in the equity’s value from the initial purchase price
Equities do not have a guaranteed return. There is always risk. Not all companies offer dividends. Or, companies may stop paying a dividend if profits decrease. The price of a stock can easily go down, due to poor company performance or adverse market conditions. The value could reach $0 if the company goes out of business.
However, if company performance is outstanding, the price of the stock may increase exponentially. Choosing the correct stock to invest in is difficult. No one can see the future. Even experts in financial markets often fail.
More on Debt
A common form of debt investment is through bonds. A bond is a loan issued by a company or government (federal or municipal). The bond issuer will pay interest to the investor. At the bond’s maturity date, the total amount of the loan will be repaid.
Bonds are also known as fixed-income securities. The interest rate and term are agreed upon upfront and do not change.
Bond certificates are issued for a specific amount. This is known as the face value, or sometimes par value. This is the amount that you pay up front, and will be repaid on the maturity date. Most bonds have a $1,000 face value, though other denominations are possible.
The fixed interest rate paid on the bond is known as the coupon (or coupon rate). This is typically an annual percentage. The coupon date is the specific date that interest will be paid. Bonds typically pay interest annually or semi-annually.
Bond terminology can feel esoteric. However, the basics are straightforward. Let’s look at a pretend example:
- A company issues a $1,000 bond. $1,000 is the face value.
- The issue date is March 15th, 2024.
- The maturity (or term) of the bond is 5 years.
- The maturity date will be March 15th, 2029. On this date, the company will pay back the original $1,000.
- The interest rate (or coupon) is 5%, paid annually.
- Once a year, the company will pay the investor $50 ($1,000 x 5%).
- By the maturity date, the investor will receive 5 total interest payments.
- Total return: $250, on the original $1,000 investment.
In general, debt securities (like bonds) represent less risk than equities (like stocks). Interest payments are fixed and predicable. Stocks carry more risk, but potentially with more upside.
Bonds are not free from risk. An issuer may go out of business, and default on repaying the loan. If a company enters bankruptcy, assets are often liquidated to repay creditors, such as bondholders. The risk remains that the bondholder will not receive 100% of the face value back.
Bonds are often rated to measure the creditworthiness of the issuer. In principle, the higher the rating, the lower the chance the entity will default on payments. Lower-rated bonds carry more risk, but often pay a higher interest rate to offset that risk.
The three leading rating agencies are Standard and Poor’s (S&P), Moody’s, and Fitch Group. All three are for-profit institutions. After the 2007-2008 financial crisis, the accuracy and impartiality of the agencies received scrutiny. As always, proceed with caution.
Each rating agency uses a slightly different rating scale, with either 9 or 10 tiers. AAA-rated bonds are considered the most creditworthy. The lowest rating is typically C or D. The highest four rating tiers are considered investment grade. Tiers below this carry much higher risk, and are considered speculative or junk bonds.
(Check out this excellent reference for more detail on rating agencies:
https://www.investopedia.com/articles/bonds/09/bond-rating-agencies.asp)
Bonds, like stocks, can be traded between investors. The trading price of a bond can go above or below the face value.
Bond prices are sensitive to changes in interest rates. If interest rates go up, existing bonds become less valuable, as they pay less interest than a new bond. Conversely, existing bonds become more valuable when interest rates decline, as they pay more interest than a new bond.
Other types of Securities
Hybrid securities combine elements of multiple securities, such as stocks and bonds. A convertible bond provides interest like a normal bond, but can be converted into company stock.
A derivative security’s value is tied to some underlying asset. Futures and options are both forms of derivative securities. For a broader overview on options specifically, check out: Beginner’s Guide to Options: Calls vs Puts.
Closing Thoughts
Both equity and debt securities are fascinating but complex financial instruments. Future articles will delve deeper into topics like trading, indexes, funds, interest rates, and tax considerations.
Best wishes!
© 2024 Aaron Balchunas
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