Investing in Debt vs. Investing in Stocks
Since 2001 the Discovery channel has been airing a documentary television series called "How It's Made" that involves showing viewers how common items that many of us find in our own homes are manufactured. This long running show has attracted an amazing following because many of us are very curious as to where and how some of the most common things in our lives are created. As human beings we are naturally curious about the other side of our consumables, and as many people who have been through the debt settlement process wonder where all the money people are lent comes from.
Two of the most common ways an investor can allocate investment capital are to invest in the equity of a company by purchasing stock either in a private offering or on a stock exchange or by lending money to a company or individual with the understanding that the loan must be repaid with interest. Lending money is the equivalent of investing in a person or company based on their creditworthiness, in other words, investing in debt. Both methods have their upsides. On the one hand, owning equity makes you a fractional owner of a company and gives you a stake in the profits. On the other hand, being a lender allows you to offer money to individuals and businesses without taking on the risk of owning the actual equity in the company which could be very difficult to liquidate in the event that the business fails or the individual decides to file bankruptcy.
Investing in debt allows you the freedom of liquidity that doesn't come with being an equity investor. When a company goes bankrupt, it's the lenders who have first dibs on any actual value left once the company and its assets are liquidated, leaving the equity investors to wait their turn and only hoping that there is anything left over once the lenders have taken their fair share. Alternatively, when a company does incredibly well, the equity investor makes exponentially greater returns than the lender, and the lender cannot make any sort of claim against the company greater than the agreed upon loan terms.
Two of the more common ways an investor can make an investment in debt is by investing in individual bonds or a bond exchange traded fund (ETF). A bond is simply a method that companies can use to gain their own investment capital from the public by allowing the public to purchase contracts that guarantee them interest payments over a certain period of time in exchange for the company being able to use a lump sum of cash that you've invested. At the end of the duration of the bond, when the bond "matures", the investor not only gets to keep the interest payments, but also gets to redeem their entire investment sum which could be reinvested in other bonds or put to use in any way they would like.
There is a large variety of bonds to choose from, but some of the more common types of bonds to invest in are:
- Fixed Rate Bonds: These are bonds that have a fixed interest rate over the life of the bond.
- Treasury Bonds: These bonds are as close to lending the federal government money as you can get and are often considered to be one of the most sound investments available as proven by the Treasury bond's quoted interest rate as the starting point for many discounting valuation models in finance.
- Municipal Bond: These are investments in your local or state government and one of the benefits of this type of bond is that very often the income received from them isn't taxed by either the Federal or State -- leaving the entirety of the cash flow received from the bond to be reinvested by the holder.
Debt has been one of the foundations for building a civilization for thousands of years and yet is one of the least understood and known about aspects of a society. Few people know that they have the option to invest in debt or even that bonds are a company's way to ask for a loan to the general public. By investing in the debt instead of the equity of a company you are helping a company grow by providing it the cash it needs without taking away a cut of the profits by purchasing its equity and becoming a partner.
This guest post was written by Eliza Collins, a seasoned personal finance writer with professional experience in the debt relief industry. Eliza writes at debtsettlement.com where you can read more about debt, hands-on debt relief strategies or services.