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What is credit investing and how does it work?
A well-diversified investment portfolio typically includes credit investments to balance risk and return. Here’s what you need to know about credit investing and how it works.
What is credit investing and how does it work?
A well-diversified investment portfolio typically includes credit investments to balance risk and return. Here’s what you need to know about credit investing and how it works.
Credit investing refers to investment in credit or debt instruments – it’s basically what institutional, professional and independent investors do when they include debt securities in their portfolio.
Debt securities can be used as defensive assets to protect your investment portfolio against market volatility and inflation – and you may already be doing it if you’re a bondholder.
Credit investing can be a good way to balance risk in your portfolio, but bonds aren’t the only products you can access.
Here’s what you need to know about credit investments and how it works.
Debt v equity investment
A diversified investment portfolio that is aimed at maximising returns and minimising risk typically includes both debt and equity investments to balance risk and return.
Debt investments function like an IOU because the bond issuer promises bondholders steady interest payments for a fixed period and full payment of the debt upon maturity. Investing in debt securities, such as bonds, is a good way to preserve their capital while earning a fixed income.
Equity investment refers to investments in publicly listed entities or companies whose equity shares are traded in exchanges. The shares investors purchase entitle them to partial or beneficial ownership in the underlying asset.
How debt securities work
Most debt securities work like bonds – with the issuer promising to pay an agreed interest on the borrowed money periodically until maturity when they must pay the face value. However, the income derived from bonds may be greater or lesser than expected depending on the type of interest rate on offer.
- Fixed-rate securities apply the same coupon rate for the entire life of the bond despite market fluctuations. This is the simplest and most common type of bond.
- Floating-rate securities refer to debt securities with coupon rates that move according to benchmark rates, such as the bank bill swap rate. This movement offers protection from the effects of inflation.
- Zero-coupon securities are debt securities that do not pay out the published coupon regularly. Instead, the issuer keeps the expected coupon payments for the duration of the bond and only pays everything – all coupon payments and the face value – upon maturity or redemption.
Note that investors must still pay tax on the coupon each year even if they don’t receive it.
Common types of debt investments
Bonds
Adding bonds to an investment portfolio is a good defensive measure to counter the volatility of equities; however, not all bonds guarantee protection and consistent returns.
- Australian government bonds
Government bonds are debt securities issued by municipal, state and national governments through their respective treasury departments.
Most government bonds are fixed-term fixed-income investment assets, but they are generally safer than other debt securities because the issuers are government entities. - Corporate bonds
A corporate bond is a debt security that corporate entities issue as a way to raise money for their endeavours. Investors who purchase the bond are, in essence, lenders to the issuing companies.
There are different types of corporate bonds with varying conditions and exposure to risk. But while the safety of your money isn’t always guaranteed, corporate bonds often offer higher interest rates – exercise due diligence and choose wisely.
Commercial paper
Commercial paper refers to short-term unsecured debt securities issued by corporate entities that are usually issued at a discount from its face value.
Mortgage-backed security
Mortgage-backed securities (MBS) are similar to bonds, but instead of lending money to government or corporate entities, the investor lends money to home buyers without being the actual lenders.
That is, home buyers still take out home loans from banks and similar lenders, but these lenders pool different home loans together and sell the mortgages at a discount to be packaged as MBS. The MBS are then sold to investors who will receive coupon payments periodically until maturity – similar to bonds.
Distressed debt investing
Distressed debt investing is similar to buying bonds but with a focus on purchasing debt investments that are trading at a significant discount because the underlying entities are at a risk of bankruptcy.
These types of assets are considered below investment grade and are therefore high-risk investments.
Explore nestegg to learn more about investing.
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