The two common types of instruments that are traded on the stock market are debt instruments and equity instruments. Debt instruments are loans and other forms of debentures that have been raised by companies as a means of financing their business operations with fixed terms of repayments and interest rates. They include bonds, promissory notes, bill of exchange, debentures, certificates, and so on. They are basically instruments of indebtedness. Equity instruments are much different. This instrument is a document, usually the share certificate that confers the right of ownership to a firm and its assets. Their gains are usually different depending on the financial state of the company. While there are fixed terms, the benefits attributable to owners vary. Hence, it’s riskiness. These two instruments can be traded on the same market, but they are a different one to the other. Here are the major differences between debt instruments and equity instruments.
Table of Contents
When it comes to debt instruments, there are fixed terms of repayment. A debt instrument clearly states the amount to be repaid by the receiver of the invested amount. It states when it should be repaid, how much should be repaid, and so on. An equity instrument, on the other hand, has no time restriction. You can have shares in a company for as long as the company exists. There are no terms for repayment and no interest accruing. Rather dividends are received as required.
As explained, there are no rules of time binding on the equity instrument. As long as you possess the contract of ownership of those shares, you can hold for as long as you want or sell when you want to. No time frame. With debt instruments, however, you have to be very careful with the time frame showed on the instrument. The time is fixed and very tight. Failure to abide by it attracts strict penalties such as higher interest rates or sometimes, more drastic measures.
When you owe money, all you have to do is repay it and also pay up the accruing interest as required. Your company is still yours. What happens is that these debts are usually tied to certain assets as collateral. Where there is a default, these assets can be seized. With equity instruments, on the other hand, shares are given, and the ownership structure is diluted.
Both debt and equity instruments have their own risk factors. With debt, the risks that could arise include the increase in interest rates following an unstable economy or the loss of an asset following a breach of the contract. As long as you remain within the terms of the contract, your risk is largely controlled. This is why it is the more favored option according to the pecking order theory. Equity instruments are tied to ownership. Hence, you are losing a part of your company with every new share you issue. You also lose a level of control over the decisions you can make as the decision-making power is now diluted as well.