Understanding Equity and Debt Markets

Equity and debt are the two fundamental aspects of finance. Each provides a different means for companies to raise money and for investors to get their returns. 

Equity represents ownership in a company. For the issuing company, this type of financing entails raising capital by issuing shares or stock, providing the investors with a claim on the residual assets of the company and on future earnings, and, importantly, this capital does not have to be repaid. For the investor, buying equity means they will become a part-owner (shareholder) in the case that the company gets liquidated. 

Debt, conversely, is capital received by a company or government in the form of bonds or loans, which will have to be paid back along with interest over a specified time period. Individuals who invest in debt instruments (bondholders) receive periodical payments of interest as well as repayment of their principal upon maturity. 

Choosing between debt or equity capital is an important decision that will affect a company’s capital structure as well as its risk profile. Just like in determining debt and equity investments, the size invested in debt and equity will define the risk and reward of a portfolio in total. Thus, by knowing these two, companies and investors will better be able to make decisions to accomplish their desired goals.

How the Equity Market Works

The equity market consists mostly of two markets: the primary market and the secondary market. 

The primary market is where corporations obtain capital by issuing shares to the public for the first time through an Initial Public Offering (IPO). The funds from the IPO are received directly by the company either to expand business or settle debt. 

After the shares are issued by the IPO, they are then exchanged in the secondary market between investors in the stock exchange. Here, the investors can buy or sell the shares whenever they want.

In order to invest in shares, an investor needs two accounts — a Demat account, where shares will be held in a digital format, and a trading account, which an investor uses to buy or sell shares with the help of a broker. Whenever an investor orders a transaction, that order is fulfilled with another transaction on the exchange — specifically a seller fulfilling a buyer's request. When the order is fulfilled, the share(s) are moved to the buyer's Demat account and cash is transferred to the seller's account. This occurs within one working day (T+1) in most cases.

Prices for shares are always fluctuating due to supply and demand. When more people want to invest in buying shares of a company, the share price goes up. Conversely, when there are more people wanting to sell their shares, the price tends to go down. Prices will also change based on corporate performance, the economy, government policies, and the moods of investors. 

Investors make money in two ways: one, through dividends, which are a portion of a company's profit that are made available to shareholders. Two, through capital gains, which are profits that are realized when selling their shares at some higher price than was previously purchased.

Numerous people participate in the equity market: investors, brokers, depositories (NSDL and CDSL) that secure holdings of shares, and clearing corporations that confirm all trades are settled correctly. SEBI ensures the market is transparent and protects investors against fraud.

While over the longer term, the equity market can offer very high returns, it also has a greater risk, as share prices can increase and decrease at a rapid pace. It is therefore important that investors do their research into the company's results and the environment of the market going forward.

Who is the Equity Market Intended For?

The equity market is meant for individuals who are comfortable with a greater risk of loss to reap long-term benefits. Since prices of stocks can fluctuate considerably in the short term, equity investors must exhibit patience, as they must deal with the ups and downs of a loss or gain. The equity market is suitable for long-term investors who are usually content in holding stocks for many years in return for capital growth.

How the Debt Market Works

The debt market, also known as the bond market or fixed-income market, is where individuals purchase and sell government, corporate, or local authority bonds. When bonds are purchased, money is lent to the issuer for a defined period.  The issuer makes the Interest payments during the life of the bond and the face value of the bond is paid at maturity.  Governments produce bonds to fund projects, while companies issue bonds to borrow money.

There are two components of the debt market which are: the primary market, where bonds are newly issued, and the secondary market, where previously issued bonds are bought and sold. Bond prices depend on interest rates. They decrease when interest rates rise and increase when interest rates fall.

In terms of risk and returns, government bonds are generally secure because the government promises to pay, but the return is less. Corporate bonds may give higher returns, but they are riskier because the company may not pay back in the future. The riskier the bond the higher the interest rate offered. The bonds are rated by agencies as Investment grade bonds or junk bonds from a score of AAA to C. With AAA being the best type of bond with least risk of default. 

Who is the Debt Market For?

The debt market is best suited for investors who are looking for safety, stability, and stable income — rather than taking large risk exposures. It is ideal for conservative investors seeking guaranteed returns who do not want their investments' monetary value to fluctuate, as is the reality in equities. Bonds and other debt securities are a suitable area for those seeking a reliable stream of interest income. This is suitable for yield-oriented investors with a need for fixed return, retirees looking for reliable income and capital preservation, and conservative investors with an appetite for security. This also contributes to portfolio diversification because debt investments can generally offset high risk investments such as stocks.

Meanwhile, governments and businesses use the debt market to borrow funds without parting with ownership. Short- to medium-term investors (approximately 1 to 5 years) can also benefit from it because debt investments tend to provide more stable and predictable returns than equities. Overall, the debt market is ideal for those who seek safe, fixed-income investments, have little time to research, and like a straightforward, hands-off method of growing their money gradually.

Comparison Between Equity Market and Debt Market

How Are Investors Prioritized in the Debt and Equity Markets?

When a company is in financial distress, liquidation, or bankruptcy, investors are paid according to a fixed priority. Debt investors precede equity investors. In the process, the assets of the Company are sold and used to pay the debt holders (creditors) first. Of them, the secured creditors — those with collateral — precede unsecured creditors. Bondholders, who are also creditors, are paid according to the terms of the bonds.

Once all debts, employee dues, and other liabilities are paid, extra, if any, is distributed to equity holders (shareholders). Since shareholders are residual claimants, they get paid last and may receive little or nothing if the company's liabilities are more than assets. This renders equity more risky than debt, yet it also has greater potential rewards when the company is operating well.

Hence, debt holders are of higher priority and lower risk, but equity holders bear higher risk but have more profit potential when things turn out right.

Investment Options in Equity and Debt

Overall, the options for investing in equity and debt include different types of investment funds or direct investments. The investor can consider the equity and debt markets based on his total investment objectives, risk tolerance, and capital to invest.

Investing in Equity Market 

• Direct Stock Investment: Investment in companies can be made by purchasing stock directly through a stockbroker. This allows the investor to become a shareholder in the company but signifies that he will need to do research himself or rely on a professional.

• Equity Mutual Funds: Mutual funds collect funds from many investors and invest in shares of different companies. Generally, professional Fund Managers administer Investing in equity mutual funds. These investments can give the investor some diversification.

• Exchange-Traded Funds (ETFs): An Index such as Nifty 50 or Sensex is tracked by these ETFs. They trade on a stock exchange like shares and typically have lower management fees.

• Portfolio Management Services (PMS): This option is for high-net-worth individuals who want an expert manager to manage their stock investments with a customized investment approach.

Investing in the Debt Market

• Bonds: An investor can purchase a government bond or a corporate bond directly. When a bond is bought, the investor is essentially investing money with the guarantee of repayment (return of investment) at the expiry date and giving permission for regular interest payments until the expiry date.

• Debt Mutual Funds: Debt mutual funds purchase a variety of fixed-income securities. These funds in turn invest in other fixed-income securities from bonds and government savings to treasury bills, to corporate bonds and so forth.  They, too, are classified by the duration of investment and an underlying credit rating.

• Fixed Deposits (FDs) and Recurring Deposits (RDs): Fixed deposits are investments made either with the banks and companies. Herein, the amount is deposited for a specific period to earn a predetermined interest rate. Recurring deposits are provided by banks and involve making regular deposits of a fixed amount each month to earn interest until maturity. Since the deposits recur at a fixed date this type of investment is called recurring deposits.

• Hybrid or Balanced Funds: Hybrid or balanced funds will invest in debt (fixed income) markets and equities (stocks) for a trade-off of return and risk, e.g. A high-growth hybrid fund will invest more in equities than a defensive fund will invest into bonds.

Equity vs. Debt – Final Take

The choice between equity and debt is based on investment aims, risk tolerance and the duration of investment. Equity is preferred where short-term market changes are acceptable. Debt investments are much less volatile and provide stable less risky income. Debt instruments are suited for investors wishing for safety, such as retirees, or for those focused simply on a fixed stable return. Debt may expect a lower average growth, but it preserves capital while providing stability in the portfolio. An appropriate investment policy will often involve a blend of debt and equity securities. Blending provides investors a way to match risk and return; equity enhances growth and debt security preserves principal and provides a predictable income stream. The specific combination will vary from person to person according to age, financial objectives, and willingness to accept risk.