Debt vs Equity Investments: Which One Is Better?
The debt vs equity investments argument has been ongoing in the investment world for years. They seem to be different sides of the same coin. Each one offers returns to an investor but has it’s own set of distinct features.
Understanding every type of debt or equity can be overwhelming, especially for a new investor. However, making the decision to start investing is the right first step to becoming a successful investor.
The second step takes a little more effort. You have to develop an investment strategy and figure out which investments fit that strategy. Are you seeking short term or long term returns? Are you willing to take on greater risk? Or are you more conservative and want to secure your principal as much as possible. These are just a few questions you have to ask yourself when you start your investing journey.
Most investments come in two flavors: debt or equity. When speaking of debt, it is not your personal debt but instead debt of the company. Equity is the amount of ownership you buy in a company. Both investment types can offer you handsome returns at different risk levels and timelines.
Both equity and debt investments are apart of the security market, each having distinct features relating to risk, return, and functionality. But how can you decide between debt vs equity investments? The only way to make the right decision is by first understanding what each one is and how they can benefit you.
Debt VS Equity Investments: Debt Instruments
In the debt vs equity investments argument, we are first going to discuss debt. Debt instruments are a type of investment that allows you to loan money to a company and receive a fixed rate of return over a set period of time. The loan can either be short term or long term. The interest rate on the loan is what determines the amount of return you will earn. The higher the interest rate, the higher the return and vice versa.
Debt instruments are generally considered “safer” than equity instruments because of it’s fixed return nature and treatment in a corporate liquidation.
Investors of debt instruments are paid a set amount of interest income at set intervals. It could be monthly, quarterly or semi-annually, depending on the characteristics of the debt. This is why they are said to have fixed rates of return.
Debt instruments are also treated more favorably in a corporate liquidation. Let’s say, for example, you buy a debt instrument in Corporation A. If Corporation A liquidates 3 months later, Corporation A has to pay you out before paying out any equity investors. As an investor in a debt instrument of a company, you are considered a lender and are treated differently than owners of the company.
Debt instruments can also experience “capital appreciation.” Capital appreciation occurs when the price of an instrument increases after you purchase it. Meaning the market value has increased. As an investor, you could decide to sell your debt instrument before maturity and realized those gains caused by capital appreciation. Capital appreciation can occur for a number of reasons. One is a decrease in interest rates, which allows companies to accept more debt financing. Another reason being an improved credit rating by the issuer (corporation), signifying the ability to timely repay higher amounts of debt.
Bonds have capital preservation. Unlike equity investments, bond issuers typically repay all of your principal at maturity. This is attractive to investors who want to preserve their principal and want to earn a little extra interest income.
Debt instruments typically come in the form of bonds. A bond is a fixed income investment where an investor loans money to an entity for a defined period of time at a fixed interest rate. The investor is commonly known as the bondholder and the borrowing entity is the bond issuer.
Characteristics of Bonds
Bonds have all of the characteristics of a debt instrument previously mentioned. In addition, bonds have what is called a “face value.” Face value refers to the amount the bond will be worth at maturity. The coupon rate of a bond is simply the interest rate the issuer will pay you based on the face value of the bond. The maturity date is the date the bond expires and the date you receive the face value of the bond. Bonds can either be short term or long term. Maturity could be a few months or a few years.
Types of Bonds
There are many different types of bonds. All having the same principal features with significant differences related to tax treatment, maturity dates, risk level and more. These factors should be considered when deciphering through which type of bond you want to invest in.
U.S. Treasury Securities
U.S. Treasury securities are considered one of the safest forms of bonds because they are backed by the U.S. government. They can be bought in denominations of $100 so are also affordable. U.S. Treasury securities can come in one of three forms: treasury bills, treasury notes, or treasury bonds.
Treasury bills are a short-term treasury security, usually with a maturity date from a few days to up to a year. The investor buys a treasury bill at a price less than the face value and receives the face value at maturity. Interest income is not paid between the purchase date and the maturity date. The interest income that is received at maturity is subject to federal income tax but not state and local tax.
Treasury notes are a long-term treasury security with maturity dates between 2 and 10 years. The principal is paid when the bond matures. Interest income is paid semiannually and is subject to federal income tax and tax-exempt on the state and local levels.
Treasury bonds are a long-term treasury security with maturity dates between 10 and 30 years. The principal is paid when the bond matures. Interest income is paid semiannually and is subject to federal income tax and exempt from state and local tax.
U.S. Savings Bonds
U.S. savings bonds are another type of U.S. backed security and are, therefore, one of the safest types of bonds. They can be bought for as little as $25. Interest income is federally taxed but not on the state and local level.
U.S. savings bonds can only be bought and sold by the entity who registered the bond. Meaning they are not any transactions in the secondary market.
Corporate Bonds
Corporate bonds are issued by companies seeking funds to operate or invest in the business. Corporate bonds are not considered as “safe” as U.S. Treasury securities because corporate bonds are backed by the company which has a higher default risk than the U.S. government. However, because corporate bondholders are still lenders of the company, they get paid before equity investors in liquidation situations.
Mortgage-Backed Securities
Mortgage-backed securities (MBS) are securities backed by homes and other real estate loans. It gives the investor the opportunity to invest in real estate without having to purchase a physical piece of property.
Mortgage-backed securities comprise of a “bundle” of home mortgages. When you purchase an MBS, you receive a proportionate amount of the mortgage payments and interest monthly. The amount of interest varies every month because new mortgages are added to the bundles. MBS typically have a minimum investment of $10,000 but this amount can vary.
Municipal Bonds
Municipal bonds are issued by state and local governments to fund projects for the general public, like roads, bridges, schools or hospitals. They are bought for minimum increments of $5,000 and have maturities between 2 and 30 years. Interest is paid semiannually and the principal is returned on the maturity date. Interest earned on most municipal bonds are tax exempt on the federal and state level. Municipal bonds are the only bonds that can be treated favorably on the federal level.
Agency Securities
An agency security is issued by a government agency, like Ginnie Mae, to fund a public project. Depending on the type of agency bond, it may or may not be backed by the U.S. government. Those not backed by the U.S. government carry more risk than those that are. Agency bonds are typically purchased in increments of $10,000 and pay semiannual interest payments.
Whether or not it is backed the U.S. government will depend largely on which agency issued the bond. For example, government-sponsored enterprises (GSEs) are not backed by the U.S. government.
The tax treatment of agency bonds varies on the agency issuing the bond. They could be tax exempt for state and local purposes or fully taxable.
Treasury Inflation Protected Securities (TIPS)
TIPS are U.S. Treasury issued bonds that protect investors against inflation risk. The principal you invest in TIPS is adjusted every year for inflation and semiannual interest payments are based on the new calculated principal.
TIPS are fully back by the U.S. government so are generally safer than other types of bonds. Because TIPS protect against inflation risk and credit risk, interest rates tend to be lower than that of other types of bonds. Maturities range from 5 to 30 years. Semiannual interest payments are state tax exempt.
International and Emerging Markets Bonds
The last type of bond is international and emerging markets bonds. They operate similarly to the U.S issued bonds except these bonds are issued by foreign companies and governments. It is not rare to see interest rates in one country moving in a different direction than another country, which is why investing in international and emerging markets bonds is a great way to diversify your portfolio. There is a minimum investment of $1,000 and semiannual interest payments are fully taxable.
International and emerging markets bonds face additional risks compared to other types of bonds. Because these bonds are issued by foreign companies and governments, there is a heightened level of country risk and currency risk. Country risk is the risk associated with the foreign government defaulting on the bond. Currency risk is the risk that the exchange rate with the foreign country will fluctuate unfavorably against the U.S. dollar.
Debt VS Equity Investments: Equity Instruments
You now have a better picture of debt instruments, how they work and the different types. Let’s take a look at the equity side of debt vs equity investments.
The underlying difference between debt and equity instruments is that debt investors are lenders to the issuer, whereas equity investors are owners in the issuer’s stock.
Equity instruments are generally considered riskier than debt instruments. The reason being that equity investment returns are dependent on the performance of the company invested in. If the company is experiencing exponential growth, its equity investors would enjoy the fruits of that labor either by dividends or capital appreciation. With debt instruments, it does not if the entity is performing well or bad, their return is based on the amount of money loaned. So what does this mean when deciding which instrument to invest into? Well, in deciding between debt vs equity investments, you have to understand the risk and reward relationship with both investment types. Let take a deeper look into equity investments.
Characteristics of Stock
Equity investments most commonly come in the form of stock. There are two types of stocks: preferred and common. An investor has the option of investing into only common stock, only preferred or a combination of both.
For every share of stock you buy, you own a piece of that company. As an owner, you are entitled to your respective share of the company’s profits. At the same time, if that same company experiences a loss, your investment loses value.
Unlike debt instruments, equity instruments do not have a set maturity date. As an investor, you can choose to hold shares of stock forever. However, you would not realize any returns if you hold onto to your stock. Returns and losses are only realized when your stock is sold.
Common Stock
Common stock is 1 of 2 types of equity investments.
They can earn you can earn you capital appreciation or dividends. Though dividends are not required to be paid by a company.
A company’s stock price fluctuates throughout the day, depending on how many investors are buying and selling a particular stock. If you chose to sell your common stock when the price went up, you would earn a capital gain.
Capital gains are taxed at both the federal and state level. Long-term capital gains are taxed at a much more favorable rate than ordinary income with the highest bracket being 20%. If you earn a capital gain on stock held less than a year, then your gain would be taxed as ordinary income.
Common stock can come with voting rights attached. Meaning as a partial owner, you can vote on issues concerning the management or any other major decisions impacting the company.
Common stock is considered to be very risky because, in a corporate liquidation, common stockholders are last to be paid. Given this risk, common stockholders have the greatest opportunity for higher returns.
Preferred Stock
The second type of stock is preferred stock. Preferred stock has the same elements of equity instruments and common stock.
Preferred stock investments usually always pay dividends and if they do, are paid before common stock dividends. Dividends on preferred stock are fixed and do not fluctuate how common stock dividends do. Another difference is the price of a preferred stock does not fluctuate as much as common stock. This would be good in times that stock prices are falling but bad in times where stock prices are rising. If you’re an investor looking to make capital gains, common stock may have more opportunity to achieve that.
Debt VS Equity Investments: Which Is Better?
The debt vs equity investments argument is not exactly clear. Both debt and equity investments offer advantages and disadvantages. It is a constant balance between risk and return. How you measure that balance is completely up to you. Maybe you like the tax advantages of municipal bonds or the capital gains potential of common stock. At the end of the day, the choice is yours. Instead of thinking of it as debt vs equity investments, think of it as debt and/or equity investments. There is no right or wrong answer. Some seasoned investors may argue one against the other but the choice of which one is better really comes down to the individual investor.
What’s Next?
How will you decide to diversify your portfolio?
Do you need more help deciding if you should buy debt vs equity investments? Consider using the financial advising services at LYFE Accounting. Contact us today!