Debt (Securities) Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Debt, in general can be understood as an amount (of money) owed to a person or organization for financial resources (funds) that have been borrowed. Debt can appear in several ways: In the form of a banking credit, in the form of securities, or in any other form that confirms that an entity (physical or a legal person) owes something to someone (specified either as a bearer or by name).

In terms of size, businesses borrow the most from banks, including the financial systems where financial markets are very propulsive. The reason for that lies in the fact that it is comparatively more difficult to raise finance in financial markets, and that the price of borrowed funds is usually higher than the interest that is under normal circumstances paid to the (commercial) banks. There are a series of securities that can be used for providing debt finance to an enterprise and they are primarily classified based on the term conditions. Companies can issue bills and/or bonds. In the former case one is looking at the term of less than a year, and in the latter case the security will mature in more than a year. There are also many varieties of these financial instruments, but the basic principles remain largely the same. Debt instruments are associated with a number of risks. Creditors are often able to claim some or all of the assets of the enterprise in the even of noncompliance with the conditions of the loan, which sometimes can result, ultimately, in liquidation. Some of the instruments can have additional conditions attached to them and there may be a requirement to keep certain financial ratios at the preferred level.

Instruments

Debt securities are bonds, commercial papers, treasury bills and treasury notes, certificates of deposit, and mortgage-backed bonds or mortgage bonds. Not all these instruments are equally and readily available. Bonds are long-term contracts in which the bondholder agrees to lend the money to the firm and in turn the firm promises to pay the bondholder interest until the bond matures. Depending on the type of bond, the borrower will pay both principal and interest, or will just pay interest in the predefined intervals, usually semi-annually or annually. The principal that is returned when the bond matures is often called the par, face, or nominal value of the bond. Bonds may be regarded as somewhat more complex “I owe you” (IOU) instruments, which are traded in secondary financial markets. The trading is usually done in an organized manner, through the Exchange and via the authorized broker. Therefore, although bonds have specified maturity, they may be sold in the market and the proceeds received would be immediately available to the bond holder, without waiting for redemption concepts.

Because bonds are fixed income instruments, they are highly dependent on the movements of interest rates. Negotiability of the bond, that is, their marketability in the secondary market, is an important feature for the investors, especially those who cannot easily plan their liquidity needs. A classical form of bond will pay out interest semi-annually and will have a specified redemption date; these bonds are known as straight, vanilla, or bullet bonds. Some bonds can be commodity indexed, or even linked with some events, and depending on the outcome of the event, the condition would come into force.

There are also different levels of security, and debentures are the most secured bonds. Debentures are usually secured by either a fixed or a floating charge against the company’s assets. A fixed charge means that specific assets are sued as security which, in the event of default, can be sold at the insistence of debenture bondholder. There are also possibilities to include some trust deeds and covenants (like the limits on further debt issuance, dividend level, limits on the disposal of assets, and keeping financial ratios at a desired level).

Investors also have an opportunity to invest in financial debt instruments that are retailed in the international financial market. The international bond market, as a subset of the international financial market, trades foreign bonds and Eurobonds. Foreign bonds are denominated in the currency of the country where they are issued, when the issuer is a nonresident. Eurobonds are those bonds that are sold outside the jurisdiction of the country of the currency in which the bond is denominated.

A security that enables short-term financing is a bill of exchange. The bill of exchange is a document that sets out a commitment to pay a sum of money at a specified point in time. Historically, bills of exchange have been used to finance international trade and as such have played an important role in providing short-term liquidity to the system.

Use

When it comes to analyzing financing of debt by securities, one must take into account the term for which the debt finance is requested. If the case is with long-term finance, one opts primarily for bonds, especially debentures (fixed-charge, floating-charge debenture, zero-coupons). There are also floating rate notes (FRNs), which are used as both long-term and medium-term instruments. Medium-term notes (MTNs) are a promise to pay a certain sum on a named date in the future. Short-term debt finance can be based on the commercial paper, mentioned bill of exchange, acceptance of credit (bank bills), or revolving underwriting facility (RUF). In either case, a borrower will issue a security of some kind or a written document. Sometimes there are limitations imposed on trading in some instruments, but not all securities are to be traded in the financial markets. In fact, some trading gives better results if a usual national blueprint is followed. In deciding how to finance its needs, a company follows the pecking order, where raising money through the issue of securities comes only after financing with retained profit and bank credit becomes the form that can be endorsed.

Debt security is a financial instrument representing the borrower’s obligation to the lender from whom he/ she has received funds. In this particular contract the contracting parties will agree on terms of repayment (most notably, the maturity) and lender’s remuneration, expressed usually as interest. Interest is in fact a price of using other people’s money. The obligation to pay provides a schedule of financial flows defining the terms of repayment of the funds and lenders’ remuneration within the time framework. As already mentioned, the comparative advantage of debt securities to the bank credits is that the former can be traded, even in very limitedly developed financial markets. In trading in the financial markets, it is important to ensure the soundness of the financial instruments traded in them, in order to ensure that stability has not been affected adversely. To have a debt security work without much trouble, it is necessary to stipulate in the contract the nominal or face value, issue price, redemption, issue date, interest rate, and periodic coupon repayment.

Redemption may have interesting variations, as the particular contract may stipulate a deferred redemption period. In this case the issuer enjoys a grace period and may focus on the activities that will secure the market position of the company, rather than wasting talent on routine operations. As the securities are (as a rule) traded on the financial market, the market price of securities is important and to a large extent the offer prices are not of much importance for future developments. Trading in the secondary market is very important for proper understanding of costs of capital. Namely, the change in the yield on the secondary market suggests clearly how much the company will have to commit in costs before even considering rising funds and services. Debt securities are generally the second, or even third, option in the pecking order, as they will always be more expensive to arrange and service than drawing financial resources from the retained profit position and securing a bank credit. Often, only after these two options are given careful consideration, a borrower will begin looking at the securities option.

Similarly, the attractiveness of the option and marketability of the instruments have led to the practice of securitization, where immobile assets are bundled together and, based on the future guaranteed or estimated cash flows, one issues securities that are large in size and have some guaranteed income (or at least easily definable future revenues).

The very practice of securitization requires as a precondition a stable financial system, a robust regulatory environment, and a high level of legal, regulatory enforcement.

Bibliography:

Arnold, Corporate Financial Management (Prentice Hall, 2005);
Peter Atrill and Paul Hurley, Financial Management for Decision Makers (Pearson Prentice Hall, 2008);
Blake, Financial Market Analysis, 2nd ed. (John Wiley & Sons, 2000);
A. Dennis, R. T. Upton, and D. W. Wile, Debt Securities (Kaplan Business Publishing, 2005);
Kelly DePonte, The Guide to Distressed Debt and Turnaround Investing: Making, Managing and Exiting Investments in Distressed Companies and Their Securities (Private Equity International, 2007);
Fabozzi, The Handbook of Corporate Debt Instruments (John Wiley & Sons, 1998);
Finnerty and D. Emery, Debt Management: A Practitioner’s Guide (Harvard Business School, 1997);
Tuckman, Fixed Income Securities, 2nd ed., (John Wiley & Sons, 2001);
Vernimmen et al., Corporate Finance Theory and Practice (John Wiley & Sons, 2005).

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