Debt (West's Encyclopedia of American Law)
A sum of money that is owed or due to be paid because of an express agreement; a specified sum of money that one person is obligated to pay and that another has the legal right to collect or receive.
A fixed and certain obligation to pay money or some other valuable thing or things, either in the present or in the future. In a still more general sense, that which is due from one person to another, whether money, goods, or services. In a broad sense, any duty to respond to another in money, labor, or service; it may even mean a moral or honorary obligation, unenforceable by legal action. Also, sometimes an aggregate of separate debts, or the total sum of the existing claims against a person or company. Thus we speak of the "national debt," the "bonded debt" of a corporation, and so on.
(The entire section is 147 words.)
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Debt (Encyclopedia of Business)
Debt is money that has been borrowed from another party and must be repaid at an agreed upon date. The cost of using this money, which also must be paid, is interest. The person or firm making the loan is called the creditor or lender. The person or firm borrowing the money is called the debtor or borrower.
Business debt may be in the form of commercial loans, term loans, or bonds. The makers of commercial or term loans are frequently commercial banks or other lending institutions. Debt can be used to finance seasonal increases in working capital; permanent increases in working capital; the acquisition of plant, property, or equipment; or for mergers and acquisitions. In addition to the requirement to pay interest, debt may also carry restrictive covenants that the borrower must satisfy to prevent default.
In contrast to equity, debt is not an ownership interest in the firm. Creditors generally do not have voting power. The firm's payment of interest is a fully tax-deductible cost of doing business, unlike dividend payments which are not tax deductible. Unpaid debt is a liability of the issuer. If it is not repaid, the creditors may legally seize the assets of the firm, which could result in either its liquidation or reorganization. Thus, a major cost of issuing debt is the possibility of financial distress. This possibility does not arise when equity is issued.
The money market is the market for debt instruments with a maturity of one year or less at the time of issuance. Short-term debt is often referred to as unfunded debt. Major types of money market instruments include: U.S. Treasury bills, commercial paper, and Eurodollar deposits. Long-term debt consists of fixed-income securities with a maturity of more than one year.
Corporations seeking to borrow large amounts frequently issue bonds. Interest-bearing bonds require regularly scheduled interest payments, usually semiannually, between the original date of issue and the maturity date. They also have a par (or face) value that is paid to the owner of the bond at the maturity date. Many corporate bonds are sold to the public. The market value of these bonds will vary as interest rates change. If a bond's market price equals its face value, the bond is a par bond. Because market interest rates fluctuate daily, the contract interest rate on the bond will seldom equal the market interest rate on the date the bonds are sold. When the market price exceeds the face value, the bond is a premium bond. When the price is less than the face value, the bond is a discount bond.
Some bonds do not require any explicit interest payments. These bonds, called zero coupons, or pure discount bonds, promise to pay a certain amount, once, at a specified time in the future and sell for less than face value.
The two major categories of long-term debt are public issues and private placements. In a public offering, the security is offered to the general public, giving an investor the right to purchase part of the new issue. The issuance process is governed by the regulations of the Securities and Exchange Commission. By contrast, privately placed securities are directly placed with an institutional investor (i.e., pension funds or insurance companies) and not offered to the public. In a private placement, the specific terms are negotiated between the parties involved. Issuers may prefer private placements because they do not have to disclose information about the firm or its plans in registration documents. Although this type of issue is more flexible, it generally carries a higher interest rate than a public offering.
THE DOMESTIC BOND MARKET
The primary raisers of funds in the domestic bond market are the U.S. Department of the Treasury, federally sponsored credit agencies, state and local governments (municipalities), and corporations. The amount of new, long-term debt financing in the United States significantly exceeds the volume of equity financing.
The largest issuer of securities in the world is the U.S. government. U.S. Treasury notes and bonds are long-term obligations of the federal government. These obligations are similar in the structure of their payment streams. Each is coupon bearing, but notes have an initial maturity of two to ten years, whereas bonds have an initial maturity of greater than 10 years, often 30 years.
Directly owned federal agencies, such as the Government National Mortgage Association (Ginnie Mae), also issue debt backed by the full faith and credit of the federal government. Federally sponsored agencies are privately owned entities, such as Fannie Mae, which also raise funds in the long-term debt markets. There is no federal guarantee, however, of sponsored agency issues. Nevertheless, agency securities are perceived as low risk, and therefore have lower yields than corporate debt, but slightly higher yields than those of comparable Treasury issues.
The largest component of the federal agency debt market is the mortgage market. Through the process of securitization, it has become common to create a mortgage pool, and then create securities based on the mortgages in the pool. Thus, illiquid individual mortgage loans are transformed into more liquid, less risky securities backed by pools of mortgages. With these mortgage pass-through securities, the mortgage servicer continues to collect payments from the borrower and passes them through to the investors in the mortgage pool. Agency-guaranteed mortgage passthroughs, issued by Ginnie Mae and Fannie Mae, provide an attractive means for investors to invest in safe residential mortgages with yields higher than those on Treasury issues.
State and local governments also issue vast quantities of securities, called municipal bonds. Interest on municipals is exempt from federal, and often state, taxes, depending on the residence of the investor. Although the stated yields on municipals are lower than on other debt instruments, when one converts the stated yields to an equivalent before-tax return on a taxable investment, the returns may be attractive. Two basic types of municipal bonds are general obligation bonds, which are backed by the "full faith and credit" of the issuer, and revenue bonds, which are repaid from revenues generated by the project they were sold to finance (such as a toll road). The corporate sector is made up of industrials, public utilities, railroads, and transportation, as well as financial issues. The municipal bond market exceeds the size of the corporate bond market, but it is not very liquid.
THE INTERNATIONAL BOND MARKET
An international bond is a bond available for sale outside the country of its issuer. Thus, if a U.S. corporation issues a bond that is available for sale both in the United States and Great Britain, the issue is an international bond. If a U.S. firm issues a bond denominated in a foreign currency for sale exclusively in the country of the foreign currency, the bond is a foreign bond.
There are a number of different types of international bonds, including straight bonds, floating-rate bonds, equity-related bonds, and Eurobonds. A straight bond is a bond with a fixed payment schedule with no special features, such as convertibility into stock or a floating interest rate. Thus, a straight bond is a conventional coupon-paying debt instrument. A floating-rate bond is a bond whose interest rate varies over time as the level of an associated interest rate fluctuates. Equity-related bonds include both convertible bonds and bonds with equity warrants. A Eurobond is a bond issued by a borrower in one country, denominated in the borrower's currency, and sold by an international syndicate outside the borrower's country. Thus, if IBM were to issue securities denominated in U.S. dollars in Europe, the issue would be a Eurobond. In recent years, the significant majority of new international bond issues have been straight bonds. Equity-related bonds made up the next largest category, with floating-rate instruments being relatively scarce.
One of the dominant forms of short-term credit in the international market is a form of bank lending called a syndicated loan loan made by a consortium of banks to a single borrower. Syndicated loans are priced as a spread above the London interbank offering rate (LIBOR). LIBOR is the rate that banks participating in the international debt market charge each other for short-term loans.
EVALUATING DEBT SECURITIES
Debt securities are evaluated on the basis of a number of factors, including yield, maturity, method of repayment, security provisions, and tax treatment. Bonds may be either secured or unsecured. Unsecured bonds, which are termed debentures, carry a higher rate of interest than secured bonds. With a secured bond or mortgage bond, the issue is backed by some asset (the collateral). Accordingly, the risk to the investor is lower, and so is the yield.
The relationship between the interest rate on a bond and the time to maturity is called the yield curve or the term structure of interest rates. Generally, the yield curve is upward sloping whereby longer maturity bond issues provide higher yields than shorter maturities. All else equal, the longer the time to maturity, the greater the fluctuation in bond prices for a given change in interest rates. Therefore, owners of longer maturity issues demand higher interest rates because of the greater price sensitivity of their bond holdings.
Bonds are scheduled to be repaid at their maturity, at which time the bondholders will receive the face value of the bond, or they may be repaid in part or in entirety prior to maturity. Some bonds include a sinking fund provision that requires periodic payments by the borrower to a sinking fund trustee for the purpose of repaying the bonds. The trustee uses the funds to retire a portion of the debt. A call provision allows the trustee to repurchase, or call, a bond issue or parts thereof, at a stated price, usually face value. The bond may also be callable for general purposes. This call price is generally higher than the bond's face value. The difference between the call price and the face value is termed the "call premium." Rather than having the entire bond issue maturing at one date, some corporations issue bonds with staggered maturity dates, known as serial bonds.
Another method of retiring bonds is through conversion. A convertible bond is a bond that gives the bondholder the option of turning in the bond and receiving in return a specified number of shares of common stock in the same corporation, thereby converting the bond into stock.
A significant feature of a corporate bond issue is the rating received by Moody's Investors Service or Standard & Poor's. The bond ratings generally range from AAA to D and reflect the risk of default on the security. Bonds rated BBB or above are termed investment grades. Those rated BB or below are termed speculative, or noninvestment grade. These bonds are also referred to as high-yield, or junk bonds.
In determining a rating, much attention is paid to such factors as cash flow and earnings relative to interest and other obligations (coverage ratios) as well as to operating margins and returns on capital and total assets. Besides financial ratios, other important factors include the nature of the industry, the relative position of the firm within the industry, and the overall quality of management.
[Robert T. Kleiman,
updated by Ronald M. Horwitz]
Brown, Patrick J., and Patrick J. Ryan. Bond Markets: Structures and Yield Calculations. New York: AMACOM, 1998.
Fabozzi, Frank J. Handbook of Bond Markets, Analysis and Strategies. 4th ed. Upper Saddle River, NJ: Prentice Hall, 2000.
, and Richard S. Wilson. Corporate Bonds: Structure and Analysis. Homewood, IL: Richard Irwin, 1996.