Debt

Debt financing involves borrowing somebody else's money with an explicit promise to repay it plus interest at a prescribed later time. Presumably the motivation for borrowing funds is the potential to employ them in an endeavor that generates rewards in excess of their costs.

Borrowing money dates to antiquity. Early loans were often extended to needy individuals. A consequent interpretation of lending then included the dimension of helping others. The question introduced by that interpretation was about the propriety of associated interest rates. Some religions interpreted the notion of charging any interest as improper. Even some sectarian rationales opposed charging interest. Notably, Aristotle reportedly used the argument that money is fallow and consequently charging interest for its use was improper. Of course Aristotle's recognition of money was in the form of gold, silver, copper and other precious metals. If one were to plant gold coins in a field, at the season's end the best he could hope for would be that nobody else had dug them. Things such as grain were not fallow, and could be planted to beget more grain.

Along with the Reformation came a new recognition of lending money. It was realized that often borrowers were not always needy souls borrowing to merely stay alive. Rather, borrowers were often more wealthy than those from whom they borrowed. Borrowers simply might have ideas they wish to actuate, and despite having considerable resources more might beneficially be used. Thus, by borrowing additional funds ambitious entrepreneurs could expand their activities.

Classification of debt

A number of classification schemes have been devised for debt instrument. These deal with many of the different characteristics that may be of interest.

Finding bond prices

Intermediary vs direct debt

Debt might be structured through an intermediary or through a direct debt issue. Intermediaries collect deposits or funds from large numbers of people and repackage them into debt instruments that are used in making loans to others. Direct loans involve bonds and similar instruments that are transferred directly between those needing funds and others providing those funds.

Intermediary provided debt

Commercial banks provide the majority of such loans to businesses.

Directly issued debt

A huge fraction of the debt employed involves no intermediary, but rather involves securities that are issued by borrowers and bought directly by lenders. These direct issues can be classified in a variety of ways.

Government debt

Sovereign states and their subordinate components (states and municipalities) issue a wide assortment of debt. In the U.S. the federal government issues debt through the treasury department. Bills, notes and bonds as described below are issued according to perceived needs and market conditions. The Federal Reserve buys some of these securities by making deposits at commercial banks that effectively monetizes federal debt into a currency. These transactions are made in the open market and the committee charged with managing such trades is consequently known as the "open market committee." When new debt is issued by the treasury primary dealers purchase it and resell it to ultimate buyers who eventually retain relatively permanent positions in it until it matures. Thus there is a period of active trading when issues are relatively new and consequently during that period prices and associated interest rates are more competitively determined. After the issue has settled into more permanent ownership the spread widens as there is less activity. During the active trading period treasury securities are said to be "on-the-run." These securities are obviously the most liquid. The less frequently traded "off-the-run" treasuries are thus less liquid. Typically after new securities with comparable maturities are issued, the outstanding ones become "off-the-run."

Protection for debt holders

One of the concerns that creditors (debt holders) have about their standing is the treatment they can expect from managers. This notion is often described as an agency problem. That is, debt holders have turned their money over to agents who are expected to manage those funds with the debt holder's interests in mind. In fact these agents also have personal interests and sometimes those personal interests differ from the debt holder's interests. A variety of devices have been introduced to minimize this problem. First there are protective covenants typically specified in an indenture agreement. Second, there are legal precedents that must be followed. Third, there are special devices such as protective puts.

Indenture agreement

The indenture agreement is an old established component of a debt agreement. The name ostensibly comes from the "teeth" found when a single page document that has all of the agreements written in duplicate. One half is retained by each party to the agreement and later enforcement of the agreement required that these halves fit together. The individual components of that agreement are often known as covenants.

Legal precedents

Established legal precedents deal with the resolution of debt settlement conflicts. The ultimate conflict of course is a default. The most obvious form of default is non payment of interest or principle when it is due. Since the debt principle is typically much greater than are the periodic interest payments, debt settlement is often subject to the "crisis at maturity" problem. Specifically, a firm might easily pay interest payments for years, but at some point when the entire debt comes due, adequate funds may be unavailable. Perhaps the firm expects to refinance the debt at maturity and finds itself unable. The debt market may have changed or the firm's financial stability may have deteriorated in the eyes of creditors. Regardless of the problem's source, when the firm is unable to pay the principle when due, it defaults on the debt. Legal means are then employed for resolution. Settlement of the debt often involves some form of bankruptcy proceedings. The relative order of claim settlement involves a hierarchical order. Those claims that have greater priority are said to be senior to claims with lower priority. For example, a mortgage bond typically specifies real property that has been pledged to satisfy the bond holder in the event of default. Thus, in contrast to a debenture which is merely a general credit obligation or simply a promise of the firm to repay that debt, a mortgage bond is more senior and the debenture is more junior. Debt settlement involves an elaborate procedure that is discussed elsewhere in depth. For now it is adequate to recognize that debts can be logically ordered from the most senior to the most junior and settlement is frequently accomplished according to the "rule of absolute priority." Thus, more senior debts are settled completely before the next level of seniority is addressed. The seniority concept extends beyond debt. That is, debt instruments in general are senior to equity instruments.

Protective puts

The use of protective puts is a more recent provision. The idea emerged in the wake of a situation created by takeover artists causing debt value to nearly evaporate due to their actions. To protect recent purchasers of debt from such actions in a takeover a protective put may accompany a newly issued bond. Then after a raider takes over the firm and issues new debt that deteriorates the value of outstanding debt, the holders of that outstanding debt are able to submit their bonds to the firm and be reimbursed at their face value.

Maturity

The time until a debt instrument matures is often considered an important parameter. Although equity instruments are generally designed to last forever, debt instruments commonly have some horizon date at which the principal will be repaid by the borrower. An exception to this rule are British Consols, an instrument that was issued in perpetuity.

Money market vs capital market

A very simple distinction is often made between highly liquid low-risk securities that mature within one year which are called money market instruments and less liquid longer term maturity instruments that are in the so called capital market. Typical instruments in the money market include Treasury bills and commercial paper. Typical instruments in the capital market include common stock, preferred stock, bonds that do not mature for at least several years, including Treasury bonds and Treasury notes.

Short-term vs long-term

This distinction is admittedly in the eye of the beholder. A common distinction introduced for accounting purposes holds that the short-term is less than one year and the long-term is more than one year. U.S. Treasuries are generally categorized as bills when they have an initial maturity under one year. Treasury notes have an initial maturity under 10 years and Treasury bonds have intitial maturities exceeding 10 years.

Mortgages

Securities may have specific assets pledged to help guarantee their repayments. For example, one of the oldest assets that may be pledged is ownership of real property such as land. In the event that the borrower does not repay the debt as agreed, the lender has the right to acquire the pledged land. Such a debt is commonly referred to as a mortgage. If no prior such mortgage exists on some pledged land, a mortgage is called a first mortgage. If a prior mortgage already exists, another mortgage may be possible if the land's value exceeds the first mortgage's amount. Such a mortgage, known as a second mortgage has rights that must be integrated with the rights of the first mortgage holder.

Equipment trust certificates

Collateral trusts

Debentures

Interest rates

Two basic structures exist for determining interest rates. The older and more traditional structure involves a constant interest rate that is set at the outset of a loan and sustained over its entire life. The second structure involves a changing rate that is periodically adjusted according to some formula established at the loan's outset.

Fixed interest rate loans

Historically an agreed interest rate is established at the outset of a loan. Parameters that enter into determining that rate are general economic conditions, time until maturity and the perceived risk of the borrower.

Floating interest rate loans

These changing rate loans are commonly known as floating rate loans. Some reference parameter, normally the interest rate on some larger and independent instrument is used to guide the floating interest rate. Commonly an appropriate difference between the external rate and the applied rate known as a spread is established and sustained.

Interest accrual

When bonds are purchased between the dates when interest is paid, the final transaction cost includes accrued interest in addition to the flat price that is quoted. Obviously if a bond is in default, no accrual is added, but otherwise accrual is a reasonable consideration. A number of conventions have evolved to facilitate calculation of an appropriate accrual fraction. Among these with applicable issues are the following:

Actual/Actual U.S. Treasury bonds and notes

Actual/365 Eurobonds, Euro-floating rate notes and many non-U.S. government bonds

Actual/360 Eurodollar deposits, commercial paper, banker's acceptances, repo transactions, floating rate notes, and LIBOR based transactions

30/360 Corporate bonds, U.S. agencies, municipal bonds and mortgages

Debt quality

Bonds that have been issued by various firms are rated by several agencies in terms of their perceived quality. Two distinctive categories are often identified. The higher is known as investment quality and the lower is known as higher risk and thus high yielding or euphemistically, "junk bonds."

Sample debt problems