Debt Issue

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Debt Issue: Definition, Process, and Costs

A debt issue is a financial instrument through which an entity—corporate or government—raises capital by promising to repay lenders according to specified terms. Common debt instruments include bonds, debentures, notes, certificates, mortgages, and leases. Investors who purchase these instruments receive periodic interest payments and repayment of principal at maturity.

How a Debt Issue Works

  • The issuer (borrower) sells a debt instrument to investors (lenders).
  • The issuer pays interest—typically called the coupon—on a scheduled basis and repays the principal (face or par value) at maturity.
  • Issuers may use the proceeds for capital projects, refinancing existing debt, or funding government programs and infrastructure.
  • Debt does not dilute ownership (unlike equity) and usually carries no voting rights.

Key Terms

  • Face value (par value): The principal repaid at maturity. Typical examples:
  • Corporate bonds: often $1,000 par
  • Municipal bonds: often $5,000 par
  • Federal bonds: often $10,000 par
  • Coupon rate: The fixed interest rate paid to bondholders.
  • Maturity:
  • Short-term bills: 1–5 years
  • Medium-term notes: 5–10 years
  • Long-term bonds: >10 years (some corporate issues can reach 100 years)
  • Yield to Maturity (YTM): The total expected return if the bond is held to maturity.
  • Credit rating: Assessment by agencies (Moody’s, S&P, Fitch) of the issuer’s default risk.

Issuance Process

Corporate Debt

  • Requires board approval and a financing proposal.
  • Investment banks and underwriters typically form a syndicate to purchase and resell the issue to investors.
  • Underwriting determines pricing based on the company’s credit rating and investor demand; underwriters charge fees.

Government Debt

  • Often sold via auctions; for example, U.S. Treasury securities can be bought directly through TreasuryDirect.
  • Government debt is generally seen as lower risk because it is backed by the government’s full faith and credit, so rates are typically lower than corporate bonds.

Costs Associated with Debt

  • Interest payments (coupon) are the primary ongoing cost and represent the issuer’s cost of borrowing.
  • The cost of debt reflects:
  • The issuer’s default risk (credit spread over risk-free rate)
  • Current market interest rates
  • Practical measures:
  • Use YTM or credit-rating-implied spreads added to a risk-free rate to estimate cost of debt.
  • Include the after-tax cost of debt when calculating a company’s weighted-average cost of capital (WACC).
  • Issuance fees: legal, underwriting, registration, auditing, and regulatory fees paid during the issuance process.

Why Entities Issue Debt

  • Raise capital without diluting ownership.
  • Interest payments may be tax-advantaged (tax-deductible for many corporations).
  • Often cheaper than raising equity if the issuer has a solid credit profile.

Risks and Drawbacks

  • Default risk: failure to make interest or principal payments can lead to bankruptcy and damage credit ratings.
  • Overleveraging increases financial vulnerability and can raise the cost of future borrowing.

Quick FAQs

Takeaways

  • A debt issue is a contractual way for issuers to borrow from investors by promising periodic interest and eventual principal repayment.
  • The process, pricing, and risks differ between corporate and government issuers.
  • Understanding coupon rates, maturities, credit ratings, and issuance fees is essential to evaluating the cost and suitability of debt financing.