Debt Financing

Terms

• Loan: A debt agreement between two parties: a borrower and a lender
• Principal: The amount of money the lender provides for the borrower to use; also known as the face value, or par value, of the security
• Maturity:Length of time in days, weeks, months, or years before a loan or a debt security becomes due for repayment. The total length of time that the agreement is in force is sometimes called the security's "term" or "tenor."
• Bond: A debt agreement in the form of a security issued by a company or a unit of government. The issuer promises to pay interest on the principal over the maturity of the bond and repay the principal when the bond becomes due.
• Note: A debt agreement in the form of a security issued by a company or unit of government with a maturity of one to five years Because notes are similar to bonds in every aspect except maturity, analysts often group notes and bonds together when referring to debt securities.

Debt Markets

• Wholesale: The wholesale (institutional) market refers to the purchase of securities by institutional investors. The retail market focuses on individual investors.
• Euromarket: The international debt markets may be referred to as the external debt markets or offshore markets. However, the most common name for the international markets is Euromarket. International market issues can take place in any location, although London is the most important issuing market. Most Euromarket issues are listed on the London or Luxembourg exchanges. These markets are not subject to the direct control of any government. Key features of eurobonds:
  • International syndicate of investment banks usually underwrites the issue and offers securities to investors in several countries at the same time.
  • Euromarket issues generally do not fall under the jurisdiction of any single country and have relatively few regulations for investors or issuers. This is a great advantage to issuers because the Euromarket enables companies to avoid many of the foreign market regulations mentioned earlier.
  • International bonds are issued in an unregistered, or bearer, form. This is an advantage to investors seeking tax avoidance, since the investor's identity is not listed anywhere.

Determining Interest Payments

• Calculations: Having set the interest rate, the interest payment is calculated by multiplying the rate of interest by the principal of the loan. For example, a loan with a principal of $100,000 and annual interest rate of 7% requires a $7,000 interest payment each year the loan agreement is in force. For debt securities, such as bonds, this interest payment is called a coupon and the interest rate is referred to as the coupon rate

• Payment conventions:

  1. Fixed Rate Payment: In some loan agreements, the borrower and investor agree on the rate of interest at the time the agreement is entered. If the rate of interest remains the same for the entire maturity of the loan, it is a fixed-rate loan. The borrower makes a periodic interest payment at a fixed rate during the time the agreement is in effect.

  2. Floating rate payment: Some loan agreements charge a rate of interest that changes over the period of the agreement. Such loans are called floating rate loans. The interest rate is based on a benchmark, such as the Treasury yield or LIBOR, plus a premium based on the creditworthiness of the borrower. The premium is usually quoted as a number of basis points or additional percentage (3- month LIBOR plus 60 basis points or 6-month Treasury plus 2%). The agreement may set the interest rate at the beginning of the interest-paying period or at the time the interest payment is due, depending on the type of security.

  3. No interest payment: Zero-coupon securities require no interest payments during the time of the agreement. The borrower receives less than the face value of the loan at the time of the agreement (i.e., the bonds are sold at a discount). A zero-coupon security charges an implied interest rate that is represented by the rate of return earned by the investor.

  Example For example, an issuer sells a $1,000 bond at a discount and receives an amount that is less than $1,000 from the investor at the time of the transaction. During the time the loan agreement is in force, the borrower makes no interest payments. When the loan is due at maturity, the borrower repays the investor $1,000

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Tags: financial system, financing, debt

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