Debt Issue

What Is a Debt Issue?

A debt issue refers to 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 or borrower, and the lender.

Understanding Debt Issues

When a company or government agency decides to take out a loan, it has two options. The first is to get financing from a bank. The other option is to issue debt to investors in the capital markets. This is referred to as a debt issue — the issuance of a debt instrument by an entity in need of capital to fund new or existing projects or to finance existing debt. This method of raising capital may be preferred, as securing a bank loan can restrict how the funds can be used.

A debt issue is essentially a promissory note in which the issuer is the borrower, and the entity buying 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 repayment of the initial principal amount on a predetermined date in the future.

In exchange for the loan, the issuer or borrower must make payments to the investors 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.

By issuing debt, an entity is free to use the capital it raises as it sees fit.

Special Considerations

When the debt issue matures, the issuer repays the face value of the asset to the investors. Face value, also referred to as 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.

Short-term bills typically have maturities between one and five years, medium-term notes mature between five and ten years, while long-term bonds generally have maturities longer than ten years. Certain large corporations such as Coca-Cola and Walt Disney have issued bonds with maturities as long as 100 years.

The Process of Debt Issuance

Corporate 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 drafts a proposal that is 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 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.

Government Debt Issuance

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 is considered to be a safe investment since it is backed by the full faith and credit of the U.S. government. Since investors are guaranteed they will receive a certain interest rate and face value on the bond, interest rates on government issues tend to be lower than rates on corporate bonds.

The 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 Standard & Poor's. A yield spread over U.S. Treasuries — determined from the credit rating — can then be added to the risk-free rate to determine the cost of debt.

There are also fees associated with issuing debt that the borrower incurs by selling assets. Some of these fees include legal fees, underwriting fees, and registration fees. These charges are generally paid to legal representatives, financial institutions and investment firms, auditors, and regulators. All of these parties are involved in the underwriting process.

Frequently Asked Questions

Why do companies issue debt?

By issuing debt (e.g., corporate bonds), companies are able to raise capital from investors. Using debt, the company becomes a borrower and the bondholders of the issue are the creditors (lenders). Unlike equity capital, debt does not involve diluting the ownership of the firm and does not carry voting rights. Debt capital is also often cheaper than equity capital and interest payments may be tax-advantaged.

What is the cost of a debt issuance?

Aside from fees paid to the underwriters who help a firm issue debt, the direct cost to the company is the coupon, or interest rate, on the bond. This represents the amount of cash that must be paid to bondholders on a regular basis until the bond matures. If this coupon rate (the bond's yield) is higher, the cost to the issuer will also be higher.

What are some risks or drawbacks of debt issuance?

If a company issues too much debt and they are unable to service the interest or repay the principal, it can default on the debt. This can lead to bankruptcy and a decrease to the issuer's credit rating, which can make it more difficult or costly to raise further debt capital.