Debt assets

When you lend money to someone you create both an asset and a liability. The person who lends creates an asset which is basically the promise to repay the money at a later date with some interest. The person who borrows inherits the liability.

The quality of the debt assets depends on the credibility of the borrower. If the borrower is likely to repay within the specified time frame then you have a good asset. However if the borrower may not be able to repay the loan then your debt asset is on shaky ground. The credibility of the borrower is a function of their income, cash flows, risk exposure and their character. Lending money to someone without a clear source of income is quite risky.

There are many types of debt assets. If you own a shop and sell goods on credit then you instantaneously create a debt asset. When you deposit money in a bank you have created a debt asset. When you lend someone money you create a debt asset. When you buy treasury bills and unit trust you create debt assets. When banks lend you money they create a debt asset.

The primary way of making money on debt instruments is from interest charged. The higher the interest rate the better. The primary risk with debt assets is default on the part of the borrower. If your friend is not able to repay your loan then you’re in trouble. The risk of default is usually factored into the interest rates. This is why banks charge more interest for unsecured loans like credit cards and salary loans.

Banks are the biggest creators of debt assets within an economy. They do this when they use your deposits to lend the money to other people including the government. The money banks lend is way more than their deposits. For example if you deposit ugx 10m in a bank, the bank can lend out say ugx 100m. This is called fractional reserve banking. Banks are only required to keep a fraction of your deposits in their vaults.

The credit generated by bank helps to stimulate spending and investment in the economy which is generally good  as people become more prosperous. The government stimulates credit growth by lowering interest rates so people can borrow more. However as more money flows into the economy inflation begins to rise and the central bank increases the interest rates. Borrowing slows as debts are repaid and the whole cycle repeats itself.

The richest people in the world have mastered how to create and leverage debt assets. They hold billions of dollars in bonds. They use mortgages to finance real estate investments. They tactfully use debt to expand their businesses.

Debt assets can be a very powerful and profitable form of assets. One needs only to understand how they work and learn to balance the risk and rewards.

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