Debt investments are a common investment type that you’ve probably encountered in your investing journey. Traditionally, debt investments are a low-risk investment which generates steady income. But there are new debt investment offerings classified as alternative investments which represent higher risk for higher reward.
This newsletter will break down the two types of debt investments, both traditional and alternative, examples of both, and how you can get started investing.
What is a Debt Investment?
Debt investments essentially represent a loan issued to a borrower by an investor, who agrees to pay interest for a term.
Traditionally, a borrower is a company, government entity, or organization who wants to fundraise for operations or projects. These forms of debt investments include corporate and government bonds, certificates of deposits, and money market funds. Investors make these debt investments to these organizations for a promised low-risk return.
The alternative version of debt investments include peer-to-peer lending, mezzanine debt, and distressed debt. These investments offer higher returns but for higher risks than bonds or CDs.
Examples of Traditional Debt Investments
Below are 5 examples of traditional debt investments. Traditional debt investments are considered less risky due to the low risk of default by the borrower and promise of steady income.
- Government bonds
Government bonds are debt securities issued by the government to finance their operations. U.S. government bonds are considered especially safe options.
- Corporate bonds
Corporate bonds are debt securities issued by companies to raise capital for operations and projects. These investments offer higher returns typically than government bonds but carry higher risks depending on the sureness of the corporation.
- Municipal bonds
Municipal bonds are debt securities issued by local and state governments to finance public projects. These bonds typically offer tax advantages because interest is often exempt from federal income tax.
- Certificates of deposit
Certificates of deposit, or CDs, are debt investments issued by banks or other financial institutions like credit unions. These short-term investment products offer fixed interest rates over a certain term and are insured by FDIC insurance, making them a more safe investment type.
- Money market funds
Money market funds are mutual funds which invest in short-term debt like government bonds. These funds offer both liquidity and stable returns.
Examples of Alternative Debt Investments
Below are 5 examples of alternative debt investments. Alternative debt investments are less liquid and are considered higher risk than traditional debt investments but offer higher potential returns.
- Peer-to-peer lending
Peer-to-peer lending is a debt investment where funds are lent to borrowers through online platforms. This investment type carries higher default risks but in return higher returns like traditional debt investments.
- Distressed debt
Distressed debt is a more-risky investment type where investors buy company or organization debt which are under financial stress. Investors buy distressed debt for the chance of purchasing debt at a discount for the potential upside of restructuring the firm or selling assets.
- Mezzanine debt
Mezzanine debt is a debt investment which provides financing to companies who aren’t ready to go public or acquire traditional financing. This debt investment often carries a high interest rate.
- Convertible bond
Convertible bonds are securities which can be converted into stock in a company at a pre-set price. These bonds offer the chance for price appreciation through conversion but carry risk like other corporate bonds.
- Real estate debt
Real estate debt provides financing for real estate initiatives. Examples include construction loans or mortgage-backed securities. This debt investment offers high yields but of course carries risk due to volatility of the real estate market.
Is Debt a Good Investment?
Debt can be a good investment for investors depending on their investment plans, type horizon, and tolerance for risk. As detailed in this guide, debt investments can range from low risk in the case of government bonds and CDs to higher risk in the case of peer-to-peer lending and real estate debt.
Investors should consider their financial situation, the rate of return they’re seeking, risk tolerance, and the access they have to alternative debt investments. If you have a low risk tolerance and want steady, low-risk returns, you should consider traditional debt investments like bonds and CDs.
If you have a fairly conservative portfolio, want a higher return, and can handle risk, alternative debt investments could be a good choice for your portfolio. Peer-to-peer investments are fairly easy to gain access to through online platforms but mezzanine debt and convertible debt is less accessible to individual investors.
How to Get Started Investing in Debt
There are 4 key steps to getting started investing in debt investments. Follow these to get started with the right option for your portfolio, risk tolerance, and income stream.
- Determine investment goals and tolerance for risk
Before getting started with debt investments, assess your investing goals and tolerance for risk. This process will help you determine whether you should invest in debt and whether you should consider traditional or alternative debt investments, and which one.
- Research debt investment options
Once you’ve determined if you should invest in debt, consider the debt investment options. This guide has listed 10 options, based on risk and return levels, as well as limitations by access. Debt investments can range from CDs to convertible bonds, and each option carries its own promise and drawback. One benefit of traditional debt investments is they are all accessible through a brokerage account while alternative investments require separate platforms or connections.
- Choose a debt investment
After you’ve researched options, it’s time to choose a debt investment. When considering your options, you should factor in potential risk, reliability of the borrower, return, and term of the investment.
- Monitor investments
Once you’ve invested, you should monitor your investment, in light of your portfolio, the market, and needs. This involves tracking your interest returns, changes to creditworthiness of the borrower, and how the market is performing.
As this guide has laid out, debt investments are a diverse investment category with a range of return potential, risk, and accessibility. Debt can be a good fit for investors who are looking for steady income and low risk as well as investors seeking more risk and reward. More research will acquaint you with each of the options introduced in this guide.
Debt is a fascinating investment category and hopefully this guide has sparked your interest in learning more and taking the plunge to diversify your portfolio.