Stocks may make all the headlines, but debt can make you rich.
Banks have known this for centuries, but they’re not the only ones with access to debt investments. From corporate bonds to tax liens, you can also reap the benefits of these wealth-building secret weapons.
After all, debt investments provide:
- Reliable income,
- Capital appreciation,
- Tax benefits,
- And stability.
If that sounds like an attractive addition to your portfolio, you’re in the right place. In this comprehensive guide, you will learn everything you need to know about debt investments. We will cover the available options, their pros and cons, and how to manage risk.
So come along as we unlock the potential of these hidden gems and discuss how low risk does not have to mean low reward.
What Is A Debt Investment?
Governments, corporations, and individuals all use debt for various reasons — to fund new projects, grow their businesses, or even cover unexpected emergencies.
Behind each of these loans is a lender, and that lender is investing in debt. They provide the money upfront, and in exchange, they receive regular and predictable interest payments.
Now, there are two primary forms of debt investments: secured and unsecured.
A secured loan is backed by collateral. Collateral is an asset used to guarantee a loan, which could be sold to repay the debt if the borrower fails to make timely payments. Car loans and mortgages are common examples of secured debt.
Unsecured debt, on the other hand, has no collateral. To convince the lender to take this greater level of risk, the borrower must pay a higher interest rate.
While debt investments can be a great source of passive income, they aren’t without risk. So it’s essential to ask the following questions before investing:
- Who is the borrower?
- Are they creditworthy?
- Why do they want the loan?
- How long will the loan last?
- What is the interest rate?
- What is my expected rate of return given the risk?
- Is there any security for the loan, and if so, how liquid is it?
Related reading: 10 Best Alternative Investments To Diversify Your Portfolio
Types of Debt Investments
There is such a wide variety of debt investments to choose from that it can be difficult to narrow your search. To help you get started, let’s look at the most popular types and the pros and cons of each.
When companies need to raise capital to fund operations, they have two options: issue debt or equity. For companies looking to raise money without giving up ownership, bonds provide an effective alternative.
When you buy a corporate bond, you are lending money to a company. In exchange, they agree to:
- Make regular interest payments for the duration of the bond
- Return your principal upon maturity
All corporate bonds are assigned ratings by credit agencies such as Standard & Poor’s or Moody’s, making it easier for investors to assess risk. These ratings range from Aaa/AAA (lowest risk) to C/D (highest risk).
|AAA||Aaa||Lowest risk||Investment grade|
|AA||Aa||Low risk||Investment grade|
|A||A||Low risk||Investment grade|
|BBB||Baa||Medium risk||Investment grade|
|BB, B||Ba, B||High risk||Junk bonds|
|CCC, CC, C||Caa, Ca, C||Highest risk||Junk bonds|
|D||C||In default||Junk bonds|
As with any investment, risk and reward are highly correlated. So lower-rated bonds pay higher interest rates but carry a greater risk of default. And AAA-rated bonds pay lower interest rates but offer more security.
However, ratings don’t always tell the whole story. For example, Standard & Poor’s gave Lehman Brothers an A rating right up until the company filed for bankruptcy on September 15, 2008.
To avoid these kinds of surprises, there is no substitute for doing your own research. But ratings do provide a good place to start. Use them to filter out “junk bonds” — anything rated lower than BBB-. And then, you can begin your research process with “investment grade” bonds (BBB- to AAA).
You can purchase corporate bonds from online brokers, banks, and discount brokers. Most charge a flat fee, with Fidelity Investments charging the lowest we’ve seen at just a $1 markup per bond.
Corporate bonds typically pay interest semi-annually, providing investors with payments twice per year. Zero-coupon bonds are an interesting exception, as they don’t make regular interest payments at all. Instead, they are sold at a discount and pay their full face value at maturity.
How To Calculate Current Yield
Bond yield is the rate of return an investor earns on their invested capital. To calculate this figure, you need to be familiar with the following terms:
- Par (or Face) Value: This is the value of the bond at maturity, and it is used to calculate the interest payments. The par (or face) value never changes.
- Market Value: The market price of a bond may fluctuate over time based on demand. A market value of 100 means the bond is selling at 100% of its face value, and a market value of 95 means the bond is trading at 95% of its face value. For example, a $1,000 bond with a market value of 90 would cost $900.
- Coupon: The interest rate paid on the bond. Interest payments are calculated by multiplying the coupon by the face value.
To determine the current yield on a particular bond, divide its coupon rate by the market value.
For example, let’s say ABC Corp needs to raise capital to build a new factory. They offer $30 million in corporate bonds maturing in five years. Bonds are issued with a face value of $1,000 at a market value of 100 and a coupon of 5. To calculate the current yield, divide 5 (coupon) by 100 (market value), and you get 5%.
However, a year into the project, interest rates have risen so demand for this bond has dropped. As a result, the market value is now 90.
If you purchase one of these bonds now, you would pay $900 instead of $1,000, and your current yield would be 5.56% (5 ÷ 90). Plus, if you hold the bond until maturity, you will still receive the $1,000 principal even though you only paid $900 upfront.
It’s important to understand that the market value does not affect the interest paid by the company. Regardless of your purchase price, the issuer will continue paying interest based on the face value of the bond.
Corporate Bond Pros
- They are highly liquid and can be sold anytime on to the large secondary market.
- They offer better returns than comparable government bonds.
- They provide consistent and predictable income.
- Bondholders are paid before shareholders in the case of default.
- It’s easy to diversify your holdings across industries.
- Credit ratings make it relatively straightforward to evaluate your risk.
Corporate Bond Cons
- Changes in demand (from inflation, interest rates, etc.) can affect bond prices and expected returns if you sell before maturity.
- The borrower could default and put your principal investment at risk.
Just like corporations, governments issue bonds when they need to raise money. And if you’re looking for the safest debt in the world, look no further than U.S. Treasuries. Considered the king of all sovereign debt (another name for government-issued debt), these bonds are backed by the full faith and credit of the U.S. government.
The U.S. Treasury offers the following types of bonds:
- T-Bills: Bonds maturing in one year or less.
- T-Notes: Bonds maturing between 2 and 10 years.
- T-Bonds: Treasury bonds maturing in 20 or 30 years.
- TIPS: These treasuries are indexed to inflation. Their par values increase or decrease based on the CPI (Consumer Price Index). When the bond matures, you get either the inflation-adjusted price or the original price, whichever is greater.
T-Notes, T-Bonds, and TIPS pay interest every six months until maturity. T-Bills, on the other hand, are zero coupon bonds meaning they are sold at a discount in lieu of interest payments.
For example, a 9-month T-Bill with a $1,000 face value might sell for $960. At maturity, the investor receives the full face value, or $1,000. The $40 gain is considered the interest paid on the bond.
Just like corporate bonds, you calculate a government bond’s current yield by dividing the coupon by the market value. A T-Bond with a coupon of 4 and a market value of 95 would give you a current yield of 4.2%. (4 ÷ 95).
U.S. Treasuries can be purchased through a brokerage, bank, or directly from the U.S. Treasury itself. And if you decide to trade before maturity, the U.S. Treasury market is one of the deepest and most liquid markets in the world, making it easy to liquidate at any time.
Government Bond Pros
- U.S. Treasuries are secure, backed by the full faith and credit of the government. But be cautious if you venture outside the U.S.
- They provide a steady and predictable income stream.
- They are highly liquid, making them easy to buy and sell before maturity.
Government Bond Cons
- U.S. Treasuries offer lower yields than corporate bonds.
- Inflation and changes in interest rates can affect bond prices and expected returns if you sell before maturity.
- The returns from investments in foreign bonds can be affected by changes in foreign exchange rates.
These bonds are issued by local, county, or state governments when they need to raise money for public work projects, such as new bridges, roads, schools, and sewer systems.
The main advantage of “munis” is that the interest paid is often tax-free at the federal level. This makes them an attractive option for higher-income investors. Most are issued in $5,000 increments, and terms can range from 1 to 30 years.
One disadvantage of munis is that they generally come with call provisions. This means the issuing government retains the right to repay the loan before maturity. If rates drop meaningfully, localities may choose to issue new bonds at lower interest rates to pay off the higher interest rate bonds.
Also, it’s important to note that municipal bonds don’t have the same secondary market as U.S. Treasuries. So, they may be more difficult to sell before maturity.
Municipal Bond Pros
- The interest paid is often tax-free at the federal level.
- They have a relatively low risk of default.
- You can earn passive income while helping the local community.
Municipal Bond Cons
- They usually offer lower yields than other debt investments.
- They are less liquid than U.S. Treasuries and corporate bonds.
- Most have call provisions.
Debentures are long-term loans that are not backed by collateral. This means that, as an investor, you can only rely on the creditworthiness of the organization.
These debt instruments are used by both corporations and governments to raise capital. In fact, they are the most common type of corporate debt. Typically, debentures have 10+ year maturities and pay interest on an annual or semi-annual basis.
Some corporate debentures are even convertible. In other words, they can be converted to equity shares at a pre-determined price at some point in the future. Converts are an excellent way to gain ownership in a company without as much upfront risk.
Debentures come in two flavors: redeemable and irredeemable.
Redeemable debentures spell out the exact terms by which they must be repaid. Whereas, irredeemable debentures have no specific maturity date. For this reason, they are often referred to as perpetual debentures.
You can purchase debentures directly from a government or corporation. In addition, many are offered on the secondary market, just like bonds. However, prices can fluctuate depending on supply, demand, and the prevailing interest rates.
- Convertible debentures can be converted to stock.
- They provide a predictable income stream.
- They have a higher priority than shareholders in the case of a company default.
- The borrower’s creditworthiness is critical.
- They have a lower priority than bondholders in the event of a company default.
If you are interested in bonds but the thought of hand-picking investments makes your head ache, debt funds are the perfect solution.
Debt funds are mutual funds that invest in fixed-income instruments, such as corporate and government bonds and corporate debt securities. They are also called Bond Mutual Funds.
With a debt fund, you can easily diversify your portfolio across different industries and bond issues. They are ideal for risk-averse investors who want a predictable income stream but don’t have the time or desire to do a lot of research.
In many cases, you can get started for as little as $250. This also makes them a great option for beginning investors.
Debt Fund Pros
- They offer greater diversification and lower risk.
- You can get started with a low minimum investment.
- They provide a steady income stream.
- They are highly liquid, making it easy to buy and sell shares.
Debt Fund Cons
- You have less control over individual investment decisions.
- Management fees can reduce your overall returns.
Consumer lending is big business. According to LendingTree.com, Americans now owe over $222 billion in personal loan debt as of December 2022, up 33% increase year over year.
With peer-to-peer lending, you can take advantage of this growing trend. Online platforms, such as Kiva and Upstart, make it easy to get started. Simply decide how much you want to lend and let them set the rates and terms.
Peer-to-peer lending offers the chance to generate higher returns than other debt investments; however, the counterparty risk is also higher. This is because it is much more difficult to determine the creditworthiness of an individual than a corporation or government.
Peer-To-Peer Lending Pros
- You can start with as little as $25.
- You can generate higher yields than corporate or government bonds.
- You decide where your capital goes.
- These platforms are IRA-friendly.
Peer-To-Peer Lending Cons
- You face a greater risk of default than most other debt options.
- Your funds are completely tied up until the loan is repaid.
Real Estate Contracts
Not every homebuyer can qualify for a traditional mortgage. And this creates a lucrative opportunity for debt investors.
Real estate contracts connect buyers with individuals, instead of banks or mortgage lenders. In exchange for loaning the money to purchase a home, investors receive a consistent monthly payment that is secured by the underlying property.
These contracts are often used as bridge loans, giving borrowers time to qualify for a conventional mortgage. As a result, the terms are usually short (from two to five years).
Real estate contracts often come with a two to five percent premium, depending on the borrower’s creditworthiness and the property’s condition. This creates a much better return profile than corporate or government bonds can offer.
For more details, check your local paper under the Financing section. Or speak directly with real estate agents or mortgage brokers specializing in private contracts.
However, there is one big caveat. You always want to be in a first-lien position. In the unlikely event of a default, this positioning ensures you are the first to be repaid after any taxes owed.
As a general rule of thumb, avoid 2nd or 3rd lien real estate contracts. Those positions run a greater risk of losing their principal investment in the event of foreclosure.
Real Estate Contract Pros
- They offer higher returns than corporate and government bonds.
- They provide consistent monthly income.
- The loan is secured by the underlying property.
Real Estate Contract Cons
- In the event of default, the foreclosure process can create extra costs.
- They tend to require more capital than other debt investments.
- They are difficult to sell before maturity if you need to access your funds.
When a homeowner is unable to pay their property taxes, the local government creates a tax lien certificate that is auctioned off to investors.
If you acquire a tax lien certificate, you are responsible for paying the delinquent taxes. Then the owner is required to repay you. This creates two potential outcomes:
- In most cases, the owner will pay the delinquent taxes. You earn the difference between what you paid at the auction, plus interest and penalties.
- If the owner doesn’t pay the taxes, you can foreclose on the property. This allows you to acquire real estate at a significant discount. But you will incur additional legal fees and you must abide by strict timeframes.
(Note: Tax liens have a higher priority than a mortgage, meaning you will be paid before any other loans against the property.)
Currently, 25 states offer tax lien certificates. One of the most profitable is Florida, which charges 18% interest and penalties on delinquent taxes. The next highest is Arizona, at 16%. In either state, you can lock in better rates of return than most equity funds at a fraction of the risk.
To get started, check to see if your state offers tax lien certificates. Then watch the local paper for announcements. If done right, tax liens can provide above-market returns with minimal downside.
Tax Liens Pros
- They are secured by real estate and give you a priority claim to the property.
- You can determine your yield based on your bid at the auction.
- Most are repaid by the homeowner.
- You have the potential to obtain real estate at a significant discount.
Tax Liens Cons
- They aren’t available in every state.
- The bidding process is highly competitive.
- You may need to go through legal proceedings if the owner doesn’t pay.
Debt Investments vs. Equity Investments
Companies can raise capital by giving up equity or taking on debt. For investors, each offers unique benefits and drawbacks.
Debt investments involve lending money in exchange for periodic interest payments and a return of principal upon maturity. They are considered less risky than equity because they are backed by collateral or the borrower’s creditworthiness.
Also, in the event of a default, debt investors have priority over shareholders. This means that if corporate restructuring or an asset sale take place, all debt holders are paid in full before proceeds are released to stockholders. If there aren’t enough funds to go around, debt holders will receive a partial repayment on their original investment, while shareholders will suffer a 100% loss.
However, debt investors have no input in the company’s decision-making. Furthermore, returns are capped to the interest paid, placing a limit on how much you can make. And if you need to sell before maturity, changes in interest rates and inflation can adversely affect the amount of money you’ll receive for your investment.
When a company issues equity, on the other hand, it must give up partial ownership to raise capital. Equity investors are entitled to a portion of the profits and have input into the company’s direction and management decisions in the form of voting rights.
The main benefit of equity investments is that returns aren’t capped. If you pick the right equity investment, your returns can be unlimited. Look no further than the financial success enjoyed by early Amazon, Tesla, and Google investors.
That being said, for every Google, there’s a Napster, and for every Facebook, a Myspace. Investors lost hundreds of millions of dollars when these companies failed to live up to expectations.
So, debt investments may not be as sexy as high-flying stocks, but they don’t suffer the same level of risks either. You may sleep better at night knowing that your debt investments will keep producing income no matter what the market does.
Why Should I Add Debt Investments To My Portfolio?
Debt investments offer benefits that could enhance your portfolio:
- Predictable income stream: Use this income to cover expenses or reinvest your returns to grow your portfolio even faster.
- Less risk than equities: Debt is backed by collateral and the creditworthiness of the borrower. It also has a higher claim in the event of bankruptcy.
- Offsets volatility: Debt is less susceptible to market gyrations than stocks and can be a stabilizing factor during market downturns.
For these reasons, many advisors recommend a 60/40 portfolio. That is a portfolio made of 60% equities and 40% bonds. This provides the best of both worlds — the growth potential of stocks and the stability of bonds.
Another benefit is that during market downturns, you can use the extra cash flow produced by your debt investments to buy stocks at bargain prices. Then when the market rebounds, your gains will compound even faster.
However, like any asset, debt has its risks. By following these 4 steps, you can maximize your risk-adjusted returns.
- Consider your timeframe: If less than three years, stick to shorter-term or more liquid options, like debt funds and short-term bonds.
- Evaluate your risk tolerance: Understanding your risk comfort level will prevent you from making emotional choices during downturns. Plus, peace of mind is much more valuable than a few percentage points.
- Seek alignment with your plan: Carefully consider how each investment fits with your long-term financial plan and how it can help you achieve your goals.
- Diversify: Don’t keep all your eggs in one basket. Spread out your debt investments to avoid the risk that any one default ruins your portfolio.
Related reading: How To Learn The Art Of Top-Down Investing: 3 Key Principles
Are you ready to put the power of debt investments to work for you?
No matter where you are in your financial journey, everyone can benefit from debt investments. Their predictable and consistent returns provide the perfect foundation for building a rock-solid passive income portfolio.
And the best thing is, you don’t need much money to get started.
Start by picking an option that appeals to you, whether a debt fund, government bond, or real estate contract. Then, do your diligence and start small.
As you gain experience, your passive income will grow. And you can use that extra money to fund new investments and kickstart the compounding process!