What Is a Debt Instrument? Definition, Structure, and Types

What Is a Debt Instrument?

A debt instrument is a tool an entity can use to raise capital. It is a documented, binding obligation that provides funds to an entity in return for a promise from the entity to repay a lender or investor in accordance with the terms of a contract. Debt instrument contracts detail the provisions of the deal, including the collateral involved, rate of interest, schedule for interest payments, and time frame to maturity.

Understanding Debt Instruments

Any type of instrument primarily classified as debt can be considered a debt instrument. They are tools an individual, government entity, or business entity can use for the purpose of obtaining capital, which must be repaid over time. Credit cards, lines of credit, loans, and bonds can all be types of debt instruments.

Typically, a debt instrument primarily focuses on debt capital raised by institutional entities, which can include both governments and companies, either public or private. For financial business accounting purposes, the Financial Accounting Standards Board’s generally accepted accounting principles (GAAP) and the International Accounting Standards Board’s international financial reporting standards (IFRS) may have certain requirements for the reporting of different types of debt instruments on an entity’s financial statements.

The issuance markets for institutionalized entities vary substantially by the type of debt instrument. Credit cards and lines of credit can be used to obtain capital. These revolving debt lines usually have a simple structure and only one lender. They are also not typically associated with a primary or secondary market for securitization. More-complex debt instruments will involve advanced contract structuring and the involvement of multiple lenders or investors, who are usually investing through an organized marketplace.

Instrument Structuring and Types

Debt is typically a top choice for raising institutional capital, because it comes with a defined schedule for repayment and thus lower risk, which allows for lower interest payments. Debt securities are a more complex type of debt instrument that involves greater structuring. If an institutional entity structures its debt to obtain capital from multiple lenders or investors through an organized marketplace, it is usually characterized as a debt security instrument. These are complex, as they are structured for issuance to multiple investors.

Some common debt security instruments are:

• U.S. Treasury Bonds
• Municipal Bonds
• Corporate Bonds

Entities issue these debt security instruments because they allow for capital to be obtained from multiple investors. They can be structured with either short-term or long-term maturities. Short-term debt securities are paid back to investors and closed within one year. Long-term debt securities require payments to investors for more than one year.

Below is a breakdown of some of the most common debt security instruments used by entities to raise capital.

U.S. Treasury bonds

Treasury bonds come in many forms denoted across a yield curve. The U.S. Treasury issues three main types of debt security instruments. Treasury bills have maturities ranging from a few days to 52 weeks. Treasury notes are issued with two-year, three-year, five-year, seven-year, and 10-year maturities. Treasury bonds have 20-year or 30-year maturities. Each of these offerings is a debt security instrument offered by the U.S. government to the entire public for the purpose of raising capital to fund the government.

Municipal bonds

Municipal bonds are a type of debt security instrument issued by agencies of the U.S. government for the purpose of funding infrastructure projects. Municipal bond security investors are primarily institutional investors, such as mutual funds.

Corporate bonds

Corporate bonds are a type of debt security instrument an entity can structure to raise capital from the entire investing public. Institutional mutual fund investors are usually some of the most prominent corporate bond investors. However, individuals with a brokerage account may also have the opportunity to invest in corporate bond issuance. Corporate bonds also have an active secondary market that both individual and institutional investors use. Corporate bonds are structured with different maturities, which influence their interest rate.

Alternatively structured debt security products

There are also a variety of alternatively structured debt security products in the market, which are primarily used as debt security instruments by financial institutions. These offerings include a bundle of assets issued as a debt security. Financial institutions and agencies may choose to bundle products from their balance sheet into a single debt security instrument offering, which raises capital while segregating the assets.