What is Debt ?
Debt is the act of borrowing money for the business or personal use. Debt securities represents the liability for the individual or a company i.e. company has the priority obligation to payback the debt amount with interest, which is the return of Investment for the lenders. It has a maturity period and borrower must repay the principal amount with interest. It is a financial obligation to the borrower.
Debt can prevail in an economy in different forms of borrowings. Personal loans, corporate bonds, government debts etc. are all the forms of debts.
Types of Debt
There are various ways for classifying debt securities. One of the common classifications of debt is based on availability of securities. Based on this, debts are of following types;
Secured Debts
Secured debts are types of debts that another asset or any form of guarantee protects for the purpose of collateral. In case of any default, the lender has the right to seize the collateral as compensation.
Bank loan, car loan, home loan etc. are examples of this types of debts.
Unsecured Debts
In this type of debt, any form of guarantee i.e. collateral is absent. In this type of debts, lender rely solely on the credibility, creditworthiness and trust of the borrower. Such debts add the risk component to the debt securities. Due to the risk factor, such debts have relatively higher interest rates.
Signature loans, student loans, credit card debt etc. are some examples of such loans.
Revolving Debts
Revolving debts is an agreement where a consumer (borrower) borrows an amount up to a maximum limit on a recurring basis. Once the borrower pays off the debt, the credit is again available to the predetermined limit
A credit card, home equity lines of credit etc. are an example of this debt.
Installment Debt
This is the type of debt in which borrower borrows a certain amount of money and repay the amount in termed and fixed installments over a set period, including both principal and interest. In this debt, the terms for debt are predetermined and payment schedule are fixed.
Auto loans, education loans, house loans etc. are some of the types of installment debt.
Features of Debt Securities
There are basically three main features of debt instruments:
Maturity
Debt instruments has a predefined date where issuer must repay the principal at face value and the incurred interest during the period. Every debt arrangement must have a maturity date. The maturity period can range from a few month to several years to even decades. Based on maturity time period, debts are of three types:
- Short term
- Medium term
- Long term
Coupon Rate
A coupon rate is a fixed or variable amount of annual interest income paid to debt holder. Coupon rate determines the amount to be paid to the lender for lending the amount. It is it the income for the lender and interest for the borrower. The coupon rate can be fixed and floating based on the agreement and nature of debt.
The value of coupon rate reflects the risk associated with the debt instruments. Secured debts have lower coupon rates and vice versa. Similarly, there are multiple factors that impacts the coupon rates i.e. maturity of the bonds, market interest rate, features of the bonds, credit rating of the borrower etc.
Principal
In debt, the borrower initially borrows the principal amount. It is the face value of a loan or bond. In simple term, the borrower receives the original sum of money, which the the principal amount, and is obligated to repay.
Common Debt Capital Instruments
Some of the common debt capital instruments are:
Loans
A loan is a liability of money, property, or other material goods taken with a promise to payback the amount with interest as promised. Individuals, business or government borrow money from any financial institutions or lenders in the form of loans. Generally loans are for financing business operations, purchasing assets, funding education, health care and for covering other expenses.
Debentures
Debenture are unsecured bonds. Debenture is an external source of debt financing where an debenture issuing company raises money for future with a promise to pay a fixed or floating interest coupon rate of return. Government and corporations with good credit ratings are eligible for issuing the debenture. Debenture are for raising long term capital.
Bonds
Bonds are the most common and widely accepted form of debt financing used by credible corporate houses and governments. It is a fixed-income instrument and borrowers pays the interest and returns the principal on the maturity date. Investors who purchase bonds are lending the money to the issuer in exchange of periodic coupon or interest payment.
Notes
Notes and bonds are of similar nature. It is a deb instrument with shorter maturity ranging from one to ten years. Corporations, Corporate houses, financial institutions and government issue the notes to raise fund for pre defined purposes. Notes may have fixed or floating interest rates.
Debt Financing Vs Equity Financing
What is Equity?
References