Straight debt is a category of investment interests that includes bonds. By purchasing straight debt, investors loan money to the entity that issues the debt. The notes that they receive may not be exchanged for any other type of asset. Holders of straight debt may hold the note until its maturity date or sell it to another investor.
Debt instruments and equity instruments are the two main types of investment in companies. Equity instruments, like common stocks, give investors a share of ownership in the profits of the company. Debt instruments, like bonds, create a debt obligation -- in essence, the company offers investors the opportunity to give loans. The purchase price of the security is the principal of the loan. The coupon payments and the face value payment that is made on the bond's maturity date repay that loan with interest.
The price of a bond is determined by the payment stream of the note. Bonds promise a certain schedule of payments. To calculate the present value of the bond, each payment is discounted by the rate that is appropriate for the date on which the payment will be made. Discount rates represent the price of waiting to receive payment. Money in the future is worth a smaller amount today because any money received today could be invested to generate returns.
Investors who purchase straight debt instruments are vulnerable to interest rate risk and default risk. Interest rate risk is the chance that the prevailing interest rate will fluctuate. The straight debt instrument locks the investor into a certain rate of return. If the interest rate rises, the investor would be better off if he were not locked into the investment because he could invest it in another asset at a better rate. Default risk is the chance that the company that issued the debt will become insolvent and will be unable to repay its obligations.
Straight debt is a pure instrument. When it is combined with an equity instrument, the resulting product is called convertible debt. A convertible bond gives investors an additional option. They can still wait for the payments or sell the bond to another investor, but they can also choose to receive stock in the company in lieu of payment. Investors who purchase convertible debt avoid some of the problems of locking in to a certain interest rate because, if the stock market goes up, they can take advantage of increased returns by taking the stock option.
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