What is Esoteric Debt
Esoteric debt refers to debt instruments and investments that are structured in a way that few people fully understand. Esoteric debt is complex and can be a product of securitization or simply a complex financing arrangement. As such, the pricing is known to relatively few market participants, and the structure may lead to seemingly attractive risk/return over other debt instruments when the instruments function properly, but can also lead to illiquidity and pricing problems when markets are disrupted. Auction rate securities are an example of an esoteric debt vehicle and are also an example of the risks, as this market has been effectively shut down since 2008.
BREAKING DOWN Esoteric Debt
Esoteric debt can refer to a range of debt investments. Some are based off collateral that isn't a traditional base from which to offer bonds or other debt securities, including things like patents, fees, licensing agreements and so on. Others offer complex payment terms to the issuing company. Pay-in-kind toggle notes, for example, are debt securities that allow a company to toggle between two options — one is to make the interest payment, the other is to take on extra debt owing to the security holder. These investments come with higher risks and, therefore, offer higher yields than regular bonds or even junk bonds. They also come with the extra issues of liquidity, as the market for complex instruments is thin at the best of times and can completely vanish during periods of uncertainty.
Esoteric Debt and the Financial Crisis
The Financial Crisis of 2008–2009 introduced the global economy to some of the risks inherent in having too much esoteric debt and too many esoteric investments in general. During this time, credit was flowing so freely that many companies and third-party issuers were creating innovative and imaginative debt vehicles tailored to whatever a particular investor wanted. The primary driver, of course, was to make a lot of money in fees and meet the financing needs of some desperate companies rather than as a favor to investors.
When the credit market seized up as companies struggled to accurately value their holdings of mortgage-backed securities (MBS) and credit default swaps, the oddball esoteric debt was considered too complex to even bother with. So, while there was a slow and painful process that eventually led to the troubled MBS being priced and then moved, the market for esoteric debt froze entirely. Without accurate pricing information, there were few buyers to help investors move esoteric debt off their balance sheets. This took down the auction rate securities market, which was once perceived as being slightly more risky than the money market. The SEC stepped in on that particular file to force settlements over improper disclosure of risk, but not all forms of esoteric debt received the same treatment.
Interestingly enough, esoteric debt began reappearing shortly after the Financial Crisis transitioned to the Great Recession. Starved for yield, investors were once again willing to take on complexity and liquidity risk for a better return. While these complicated instruments may be more attractive than plain vanilla debt in good times, they can present immense problems when the credit markets tighten.