debt instruments

Debt has played a role in economic life since the dawn of human commerce and has become a science in its own right.

Incurring economic debt is borrowing from another on specific terms, and the various debt instruments available merely represent different sets of terms required by each instrument.

The reason for unifying the terms is to allow the debt securities to be traded on a secondary market, thus increasing their liquidity and legitimacy as well as their popularity.

The premise of debt is that higher return is the reward for greater risk, and this is ingrained in the theory underlying debt instruments. This theory begins with the creation of an instrument or actual document that represents a promise by one party to repay the other under certain conditions. Typically, in heavily traded securities like these, the debtor is referred to as the “holder”. This allows the document to be traded efficiently, but the issue of security is of concern in case someone should unknowingly lose possession of the document. Fortunately, trading in these documents is now electronically regulated and therefore physical possession of securities, while not uncommon, is practically irrelevant.

The promise of repayment is linked to the condition that a price for the loan privilege or the interest is also repaid. To facilitate this process, debt securities have evolved into those that have a face value and are discounted from that face value. The amount of the discount from face value reflects the interest rate charged on the debt. Thus, a lender buys a debt instrument for less than face value and receives full face value upon payment of the debt. This gives the instrument a price that can easily be compared to the value of most other goods and services, as there is a profit in buying it at a lower price than you are selling it.

Looking at this “buy low and sell high” concept in reverse, it is clear that a lower price means a greater return when redeemed at par, and therefore a higher interest rate. Conversely, a higher price means a lower interest rate when the face value is redeemed.

Therefore, one can see that while it is profitable to buy low and sell high, it is the opposite in terms of interest rates or yields, since to profit in terms of yield one must buy a high interest rate, ie lend at a high one interest rate and sell at a low interest rate, ie borrow at a low interest rate.

Actual interest rates will differ depending on the risk or creditworthiness of the issuer of the instrument, the safest and least risky being the Bank of England and the riskiest being a promissory note from a colleague with a gambling problem who applies to you for a loan in the canteen.