Introduction to Debt Securities
“There are different ways in which businesses can borrow money. In practice, a business can finance its ongoing operations by borrowing either through a loan or debt securities from a variety of financial institutions. This article will look at these two commonly used methods to raise finances and factors that influence the choice of financing”.
Reading Time: 3 Minutes
- Introduction to Debt Securities
- What is Debt Securities
- What would you do next?
What is Debt Securities
Debt Securities are financial assets. They are created when investors lend monies to businesses. Essentially, It is a document issued by a borrower (business/company) evidencing a loan which can be a bond or fixed-income security.
The document also states the amount borrowed, the due date of the loan and the rate of interest to be paid. Generally, larger or higher amounts of borrowing are always better met by issuing debt securities. When issuing debt securities, only Public Limited Companies are legally allowed to issue them.
It is worth noting that it is cheaper to borrow through debt securities, that is, capital markets than to borrow through a loan. However, bond issues can cost more money than loans because of the administrative burden of resorting to a bond issue. The source of funds is directly from the investors as opposed to going through a middleman, the banks, who will charge the businesses for their costs of arranging these funds. Another advantage of using capital markets is that it is a wider market and there a lot more investors ready to invest and take a risk.
Further, the market is more liquid and provides easier access to cash, as stated above the market is investor based and these investors are more willing to take the risk and accept lower returns as compared to the banks.
When borrowing under debt securities, the credit rating of the borrower is important. This indicates the financial and business health in terms of how the credit market should assess whether or not a borrower is a viable bet. The borrower will struggle if they are below the investment grade.
Borrowing under a loan
This is usually done through banks and these loans are commonly known as syndicated loans. This is where different banks come together as lenders to loan a certain sum of money to a company. The commercial bank where the company decides to go to, structures, arranges and administers the loan. This will be the lead arranger. The syndicated loan operates as an ordinary loan with interest rates and a repayment due date.
A syndicated loan is flexible in terms of access to cash. One can split the cash between a revolving credit facility which is much like an overdraft, it allows the company to dip in and out of the fund of money. The other part is a term loan where you have all the cash all at once. For instance, if a company wanted to borrow 10 million but does not actually need all the 10 million at once, the company can have the 8 million as a term loan all at once and the other 2 million as a revolving credit facility which would be more flexible and suit the company needs much better. This cannot be done with debt securities.
Syndicated loans tend to be stricter for instance grace periods if the company defaults on a payment and you may have a certain period of time to pay that money, the grace periods in debt securities tend to be more generous. On the other hand, however, the borrower tends to have a relationship with some or all of the other syndicate banks and so if things start to go wrong, there is a possibility for the borrower in a syndicated loan to negotiate some flexibility.
Syndicated loans also have a lot of more flexible repayment options. The company can decide to pay in regular installments or a balloon payment where payments are made on regular installments and the one large final payment. Debt securities on the other hand are repaid by bullet payment on the maturity date. That is where all the money is paid all at once.
In summary, for a company to choose which choice of financing, it comes down to the requirements of that specific company in terms of what works best for them.