Individuals, businesses and governments use common types of debt instruments, such as loans, bonds and debentures, to raise capital or generate investment income. Debt instruments essentially act as an IOU between the issuer and the purchaser. In exchange for a lump sum payment, the lender guarantees the purchaser full repayment of the investment at a later date. The terms of these types of contracts often include the payment of interest over time, resulting in cumulative profit for the lender.
Loans are possibly the most easily understood debt instrument. Most people utilize this type of financing at some point during their lives. Loans can be acquired from financial institutions or individuals and can be used for a variety of purposes, such as the purchase of a home or vehicle or to finance a business venture.
Under the terms of a simple loan, the purchaser is allowed to borrow a given sum from the lender in exchange for repayment over a specified period of time. The purchaser agrees to repay the total amount of the loan, plus a pre-determined amount of interest for the privilege.
Bonds are another common type of debt instrument issued by governments or businesses. Investors pay the issuer the market value of the bond in exchange for guaranteed loan repayment and the promise of scheduled coupon payments.
This type of investment is backed by the assets of the issuing entity. If a company issues bonds to raise debt capital and subsequently declares bankruptcy, the bondholders are entitled to repayment of their investments from the company's assets.
The primary difference between debentures and other types of bonds is that the former have no such asset backing. Debentures are most often used as a means of raising short-term capital to fund specific projects. The bondholders' investment is expected to be repaid with the revenue those projects generate. This type of debt instrument is backed only by the credit and general trustworthiness of the issuer. Both bonds and debentures are popular among investors because of their guaranteed fixed rates of income.