A financial instrument can be classified by the type of claims that the investor has on the issuer. A financial instrument in which the issuer agrees to pay the investor interest plus repay the amount borrowed is a debt instrument. A debt instrument, also referred to as an instrument of indebtedness, can be in the form of a note, bond, or loan. The interest payments that must be made by the issuer are fixed contractually. For example, in the case of a debt instrument that is required to make payments in U.S. dollars, the amount can be a fixed dollar amount or it can vary depending upon some benchmark. That is, the dollar interest amount need not be a fixed dollar amount but may vary with some benchmark. The key point is that the investor in a debt instrument can realize no more than the contractual amount. For this reason, debt instruments are often referred to as fixed income instruments.
In contrast to a debt obligation, an equity instrument specifies that the issuer pay the investor an amount based on earnings, if any, after the obligations that the issuer is required to make to investors of the firm’s debt instruments have been paid. Common stock and partnership shares are examples of equity instruments.
Some financial instruments fall into both categories in terms of their attributes. Preferred stock, a financial instrument that issued in the United States, is an example. This financial instrument has the attribute of a debt because typically the investor is only entitled to receive a fixed contractual amount. However, it is similar to an equity instrument because the payment is only made after payments to the investors in the firm’s debt instruments are satisfied. Another “combination” instrument is a convertible bond, which allows the investor to convert debt into equity under certain circumstances. Because preferred stockholders typically are entitled to a fixed contractual amount, preferred stock is referred to as a fixed income instrument. Hence, fixed income instruments include debt instruments and preferred stock.
The classification of debt and equity is important for two legal reasons. First, in the case of a bankruptcy of the issuer, investors in debt instruments have a priority on the claim on the issuer’s assets over equity investors. Second, in the United States, the tax treatment of the payments by the issuer differs depending on the type of class. Specifically, as we explain in later chapters, interest payments are tax deductible to the issuer while the distribution of earnings to equity investors (referred to as dividends) are not.