What is a Debt Issue
A debt issue is a financial obligation that allows the issuer to raise funds by promising to repay the lender at a certain point in the future and in accordance with the terms of the contract. A debt issue is a fixed corporate or government obligation, such as a bond or debenture. Debt issues also include notes, certificates, mortgages, leases, or other agreements between the issuer (the borrower) and lender.
BREAKING DOWN Debt Issue
When a company or governmental body decides to take out a loan, they may receive financing from a bank or choose to issue debt to investors in the capital markets. The latter route may be preferred given that securing a loan from a bank may have restrictions on how the funds are to be used. A debt issue is simply the issuance of a debt instrument by an entity in need of capital to fund new or existing projects, or to finance existing debt. A debt issue is a promissory note in which the issuer is the borrower, and whoever buys the debt asset is the lender. When a debt issue is made available, investors buy it from the seller who uses the funds to pursue its capital projects. In return, the investor is promised regular interest payments and also a repayment of the invested principal on a predetermined date in the future.
Features of a Debt Issue
Corporations and municipal, state and federal governments offer debt issues as a means of raising needed funds. Debt issues, such as bonds, are issued by corporations to raise money for certain projects or to expand into new markets. Municipalities, states, federal, and foreign governments issue debt to finance a variety of projects such as social programs or local infrastructure projects. In exchange for the loan, the issuer (borrower) must make payments to the investors (the lenders) in the form of interest payments. The interest rate is often called the coupon rate, and coupon payments are made using a predetermined schedule and rate.
When the debt issue matures, the issuer repays the face value of the asset to the investors. Face value, or par value, differs across the various types of debt issues. For example, the face value on a corporate bond is typically $1,000, municipal bonds often have $5,000 par values, and federal bonds often have $10,000 par values.
In terms of maturities of a debt issue, short-term bills typically have maturities between one and five years; medium term notes mature between five and ten years; and long term bonds generally have maturities longer than 10 years. Certain large corporations, such as The Coca-Cola Company and The Walt Disney Company, have issued bonds with maturities as long as 100 years.
The Process of Debt Issuance
Issuing debt is a corporate action which a company's board of directors must approve. If debt issuance is the best course of action for raising capital, and the firm has sufficient cash flows to make regular interest payments on the issue, the board would draft a proposal which will be sent to investment bankers and underwriters. Corporate debt issues are commonly issued through the underwriting process in which one or more securities firms or banks purchase the issue in its entirety from the issuer and form a syndicate which is tasked with marketing and reselling the issue to interested investors. The interest rate set on the bonds is based on the credit rating of the company and the demand from investors. The underwriters impose a fee on the issuer in return for their services.
The process for government debt issues is different since these are typically issued in an auction format. In the United States, for example, investors can purchase bonds directly from the government through its dedicated website, TreasuryDirect. A broker is not needed, and all transactions, including interest payments, are handled electronically. Debt issued by the government are considered to be the safest investments, given that the issue is backed by the full faith and credit of the US government. Since investors are guaranteed that they will receive any interest rate and face value on the bond, interest rates on government issues tend to be lower than rates on corporate bonds.
Cost of Debt
The interest rate paid on a debt instrument represents a cost to the issuer and a return to the investor. The cost of debt represents the default risk of an issuer, and also reflects the level of interest rates in the market. In addition, it is integral in calculating the weighted-average cost of capital (WACC) of a company, which is a measure of the cost of equity and the after-tax cost of debt.
One way to estimate the cost of debt is to measure the current yield to maturity (YTM) of the debt issue. Another way is to review the credit rating of the issuer from the rating agencies such as Moody's, Fitch, and S&P. A yield spread over US Treasuries, determined from the credit rating, can then be added to the risk-free rate to determine the cost of debt.