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The Issues Involved With Debt Financing Finance Essay

Debt financing is a form of financing and a source of capital for firms where firms borrow money from investors with a promise to pay the principal with a certain interest at a future date. Debt financing is also referred to as "leveraging". The two primary sources of debt capital are debt market and bank financing. The major difference between bank financing and debt markets is that in bank financing the company and the lending institution enter into a negotiated agreement directly whereas company issues securities for investors to purchase in debt markets. Debt securities are of various types with different structures and maturities. Majority of the debt financing takes place through sale of marketable securities (such as notes or bonds) or sale of a sensitized instrument.

Participants: The main participants of the debt markets are the same as those present in other markets: Investors (lenders) & Issuers (Borrowers). The issuer may raise capital by selling the debt securities directly to the investors or taking the help of an intermediary like a broker or dealer.

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Issuers carry out the activity of raising capital from the debt markets. The term "issuer" is used only for those entity that sell marketable securities in the debt market. Any person borrowing money for the purpose of buying a new vehicle is not called an issuer, but a firm issuing bonds for funding a new project can be called an issuer.

Major Companies, Corporations, Governments and Government Agencies are issuers of securities in the debt market. The above group accounts for all the major debt securities sold to investors.

The debt market consists of two types of two types of investors: Wholesale & Retail.

Wholesale markets consist of institutional investors like - mutual funds, pension funds, banks and insurance companies. They lend the maximum amount of money in the debt market, helping issuers raise capital. Institutional investors have more influence over the market activity.

The Retail market consists of individual investors who buy the securities and invest a nominal amount as compared to institutional investors.

Types of Markets

The debt market is divided into two groups: National and International markets. The classification is made on the basis of the location of the issuer relative to the country where the investors reside.

National Market: It is a market where securities are traded within a country and is often called an "internal debt market". National market has two parts: Domestic market and Foreign Markets.

Domestic Market: In this market securities are traded in the same country as the issuing company. For example an Indian company issues rupee-denominated bonds. If these bonds are traded in India then they are a part of the domestic market.

Foreign Market: The issuing company belongs to a particular country and the bonds are issued in a country elsewhere. For example dollar denominated bonds issued by an Indian company and are traded in the United States of America. Foreign bonds have specific country oriented nicknames. For example if a bond issued in Japan would be called a samurai bond. Dollar denominated bonds issued by a Mexican company traded in the US would be called a Yankee bond. The foreign bond in the UK is called a bulldog bond and in Spain they are called Matador bonds.

The issue of securities by companies in a foreign country is regulated by the national government. Certain rules specified are:

Type of security that may be issued

Size of the issue

Credit standard for the issuer

Standard for information disclosure

Restrictions on the type of institutions that may issue securities

International market: Also known as external of offshore market. International issues can take place in any country specific location but the most important location is London. Such international markets are also called Euromarkets. These Euromarket securities are either listed on the London or Luxembourg exchanges. The advantage of such a market is that it is free from any government control or regulation. The Euromarket issue is differentiated on the basis of the currency in which the issue is denominated. A Eurobond issued in dollars is called a Euro-dollar bond. There are other important currencies like British Pound, Canadian Dollar, Japanese Yen, and Swiss Franc. Some features of the Euromarket bond issues are:

Euromarkets do not fall in the jurisdiction of a particular country and hence companies can avoid various rules and regulations of foreign markets.

International bonds are issued in an unregistered or bearer form which allows investors to hide their identity. This advantage can be used by investors to avoid tax.

An international group of investment banks usually underwrite such issues and offer the securities to investors in different countries at the same time.

Trading of Debt Securities

There are two types of transactions in debt markets:

Primary market: transactions take place when a borrower receives capital from an investor with an agreement specifying the payment of interest and principal details. Such a transaction directly affects the capital structure of the borrower.

Secondary market: transactions take place when investors trade securities in the open market. These transactions have no effect on the issuer of the securities.

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The debt securities can be processed at various clearing houses. Most open economy countries have multiple markets where the debt securities can be bought and sold.

Provisions for paying off debt

There are certain terms of the debt agreement which specify the manner in which the loan is to be repaid to the investor. Debt agreements require the borrower to:

Make interest payments for the use of funds

Pay the principal amount

Factors affecting the interest payments

An interest is calculated to find the outstanding interest payment the borrower has to make. The rate of interest to be paid depends on a number of factors like real risk free rate, inflation, credit rating of the issuer and the term of the loan.

Real risk free rate: It is the base component of the interest rate and is determined by conditions of the economy and preference of users over present and future consumption. The real risk free rate is difficult to isolate from other factors and analysts believe that it has fluctuated 2%-4% over the years. Analysts often use rate on short term treasury bills as an approximation for the real risk free rate.

Expected inflation: It is an important factor in determining the interest rate. Also the investor sentiments about the future inflation of the economy affect the current interest rates.

Credit rating: A bonds rating is used to indicate its relative probability of default, which is the probability of the issuer not making timely interest and principal payments as promised in the indenture. Companies with high credit ratings have to pay lesser interest rates whereas lower rate bonds have more default risk and hence they must pay a higher rate of interest to compensate investors for taking a greater risk. In every country government bonds have the highest credit rating since they have the backing of the government. The major credit rating agencies in India are CRISIL and CARE. In the US Moody's and Standard & Poors are the biggest agencies.

Time length of loan: The duration for which loans are taken also play a great role in determining the interest rates. A company taking a loan for 10 years would pay a different rate than a company borrowing for 10 days, all other factors being equal. The relation between short term and long term rates is called yield curve. Yield curve gives the relation between maturity and yield.

Determining interest payments

For debt securities like bonds the interest payments are called coupons and the interest rates are called coupon rates. There are three standard ways in the borrower can pay interest to the lender: fixed rate payment, floating rate payment and discounted securities (no interest).

Fixed rate payment: The borrower and the lender agree on a fixed interest rate during the time the agreement is entered. If the rate of interest remains the same for the entire duration of the loan then it is called a fixed rate payment. The borrower makes a fixed interest payment during the term of loan until maturity.

Floating rate payment: these are loans for which the coupon interest payments over the life of the security vary based on a specific interest rate or index. Also they have coupons that are reset periodically based on the prevailing market interest rates. The most common procedure for setting the coupon rates on floating rate securities is one which starts with a reference rate such as the London Interbank Offered Rate (LIBOR) plus a stated margin from the reference rate. The agreement may set the interest rate at the beginning of the period of when the interest payments are due depending on the securities.

Discounted Securities: Zero coupon securities do not pay periodic interest. They pay the par value at maturity and the interest results from the fact that zero coupon securities are initially sold at a price below par value. Sometimes we will call debt securities with no explicit interest payments pure discount securities.

Principal Payments

There are various methods like bullet payment, sinking fund and callable debt methods to pay the principal amount of the loan.

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Bullet Payment: It is the most common method of payment. In this method the borrower pays the interest during the term of the loan and repays the entire principal at the maturity of the loan. Many government securities and corporate bonds use this payment method.

Sinking Fund: The issuer requires a large amount of money to repay the face value of the loan and to facilitate that he may set up a sinking fund provision to gradually repay the loan. Many debt agreements may specify the need to set up such a fund. A trustee is appointed to monitor the periodic payments into the fund by the issuer. The payment of the principal is based on the depreciation schedule of the assets purchased with the borrowed capital. Sinking funds require the issuer to retire some bonds before maturity. This may be done by repurchasing them in the open market or selecting some bonds at random and purchasing them from the investors at a specified price, depending on whichever price is lower. The bonds are chosen randomly on the basis of their serial numbers when the issuer purchases directly from the investor.

Callable Debt: Some bonds provide an option to the issuer to repurchase the bonds at a predefined price. The repurchase price is called "call price". If a company issues bonds at a higher rate and the current market rate move to a lower rate, the debt is considered expensive. The current market rates represent the payment the bond is expected to make over the maturity of the bond. A callable bond allows the issuer to repurchase bonds at a price lower than that offered by the market. Thus investors may not get full value of bond as they would get in the open market. In callable bonds the issuer compensates the investor for a possibility of the bonds being called. Investors are compensated by the higher rate of return on similar bonds without the call provision.

Classifying Debt Securities

Debt securities are classified as secured and unsecured. Secured debt securities have a specific backing or collateral and hence pay a lower rate of interest to the investor. Debt securities may also be classified on the basis of the priority of claims on the assets in case of bankruptcy. Debt securities can be classified into: mortgage bonds, collateral trust bonds, guaranteed bonds, debentures, and asset backed securities.

Mortgage Bonds: Such bonds give the investors right to claim the pledged assets in case of default. The bondholder can sell the pledged assets to satisfy unpaid obligations. Although the bondholders have the right, it is unusual for the assets to be sold. In case of default the organisation goes under restructuring and provides a settlement for the bondholder. Mortgage bonds pay a lower rate of interest due to their asset backing.

Collateral Trust Bonds: Some companies do not own any fixed assets which can be set aside as collaterals. These companies are holding companies of the parent company and own securities of the company. They satisfy the demand of investors for backing of security by pledging assets like notes, bonds and stocks. In case of default the obligations of bondholders is satisfied by selling the collateralised security.

Guaranteed Bonds: Such bonds have a backing of firms other than the issuing firm. In most cases it is the parent company which provides the guarantee. The guarantee is for different components of the bond like interest, principal etc. This provides the investor with a strong sense of security and hence the issuer pays a lower rate of interest. The guarantor firm provides funds in case of a default.

Debentures: These are unsecured bonds. Debentures are not backed by any assets. Such bonds are only issued by companies which have a strong credit rating. The investor is a general creditor of the company. In case of default the claims of debenture holders are satisfied after that of secured bond holders. Debenture holders do have claim on assets before equity holders. The investors are compensated for the lack of security by providing a high rate of interest.

Asset Backed Securities: These are securities which are backed by a pool of mortgage loans which not only provide collateral but also the cash flows to service the debt. An asset backed security is any security where the collateral for the issued securities is a pool of mortgages. Investors receive their interest and principal earnings generated by the pool of loan. There are various types of asset backed securities like credit cards receivables, residential and commercial mortgages, automobile loans, truck leases etc. The term securitisation is the process of combining many similar debt obligations as the collateral for issuing securities.

Priority of Claim

The position of a bondholder can be classified as either "senior debt" or "subordinate debt" in case of reorganisation or bankruptcy of an organisation. Senior debt has the highest priority of claim on assets. Secured debt is also known as Senior debt. Subordinate bonds are last in the line of credit to claim on the assets of the issuer. The issuer pays a higher rate of interest for subordinate debt as compared to senior debt.

Debt Instruments

Debt instruments can be classified on the basis of their maturities. Debt can be short term, medium term or long term.

Short term markets

Debt instruments in short term markets are often called money market or cash market securities. The securities mature in one year or less than a year. All the securities have active secondary markets. The commonly used instruments are:

Treasure bill: They are issued by the US treasury and are backed by the full faith and credit of the government and hence they are considered to be free of credit risk. T-bills have a maturity of less than one year. They are generally sold at a discount to the par value and interest received is the par value paid at the maturity. Treasury bills are like zero coupon instruments. They are auctioned every month to issue three month, six month and 52 week securities. Treasury bills are quoted on a 360 day year. The market for T-bills is very liquid and generally institutional investors participate in the market.

Bankers Acceptance: These are essentially guarantees by the bank that the loan will be paid. It is a bill of exchange that directs the accepting bank to pay a third party a sum of money at a specified future date. Bankers acceptance is a non interest bearing security and is generally sold at a discount and redeemed at face value at maturity. Validity of an acceptance is from two to six months. Also it gives lesser yields as it is less risky than a commercial paper. They are created as a part of commercial transactions, especially international trade.

Commercial paper: It is a short term, unsecured debt instrument used by companies to borrow money at rates lower than bank rates. Commercial paper is issued with maturities of 270 days or less, since debt securities with maturities of 270 days or less are exempt from exchange registration. Most issues have a maturity of 2 days to 90 days range. The factors that determine the interest rate are:


Amount to be borrowed

General level of interest rates

Credit rating of the issuer

Commercial paper is typically issued as a pure discount security and makes a single payment equal to the face value at maturity. There is no active secondary market for commercial papers and the buyers hold it till maturity. Commercial paper is generally issued by companies having a strong credit rating. Traditionally manufacturing and industrial firms used to issue commercial papers but today large financial institutions such as banks, government agencies, and foreign companies have entered the market. The investors are usually institutional investors like pension funds, money market funds and certain firms seeking a short term investment.

Certificate of deposit: They are usual issued by banks and sold to their customers. They represent a promise by t he bank to repay a certain amount plus interest after a certain time period. In that way they are similar to a bank deposit. CD's are issued in specific denominations and for specific time periods that can be of any length. Typically bank CD's carry a penalty to the owner if the funds are withdrawn earlier than the maturity of the CD. CD's have a minimum maturity of 14 days and is commonly in the range of one month to six months. CD rates are quoted on a 360 day year basis and give a rate higher than T-bills due to the credit risk associated with the issuer and lack of liquidity in the secondary market. Yields on such instruments are determined by the:

Credit rating of the issuer

General level of interest rates

Supply and demand for the securities

Recent additions to CD include Floating rate CD's, Yankee CD's, Euro CD's.

Repurchase Agreements: It is an investment tool used by investors with funds available for short term investments. It is an arrangement by which an institution sells a security with a commitment to buy it back at a later date at a specified price. The repurchase price is higher than the selling prince and accounts for the interest component. Interest is the difference between the sale price and purchase price and is called the repo rate. Repurchase agreements are not regulated and the rate paid is usually less than that paid on bank financing. The collateral position of the lender is better in an event of bankruptcy of the dealer since the security is owned by the lender. Common lenders are municipal governments and securities dealers.

Medium Term Markets

Medium term market maturities are in the range of one year to ten years. They often overlap with short term and long term market instruments. Medium term markets consist of two types of securities:

Treasury Notes: Notes are semi-annual coupon paying securities with interest rates fixed at issuance and are issued by the US treasury department. Full faith and credit of US government backs these securities. The notes are issued through a monthly or quarterly auction. The market for this security is very liquid

Medium Term Notes: MTN's need to be registered with the securities exchange. Once registered these securities can be sold placed on the shelf and sold in the market at the discretion of the issuer. MTN's provide maturities varying from 9 months to as long as 100 years. Issuers provide maturity ranges usually 18months to 2 years for the notes they wish to sell and provide a yield quote for the ranges as a spread comparable to the maturity. The offering of the MTN's is done on a best effort basis. MTN's can have a fixed or floating rate coupons and can be denominated in any currency can have special features like caps, floors etc. Typical issuers are companies with high credit ratings.

Long Term Markets

Instruments with a maturity of 10 years and above belong to this category. However there are certain MTN's with maturities of 20 years and 30 years which overlap and hence the division is not clear. Most common instruments include:

US Treasury Bonds: The treasury bonds are highly liquid bonds with maturities of 10, 20 and 30 years. They offer semi-annual coupons and are auctioned monthly or quarterly. These bonds are also backed by the credit of the US government. Mostly institutional investors are the largest participants in this market.

Corporate Bonds: The corporate bond market is very large. The overall level of interest rates and issuer's credit rating determine the interest paid on corporate bonds. Majority of the bonds are underwritten. After careful analysis the value of each bond feature is calculated and combined to estimate the value of the entire instrument. There are plain vanilla bonds which are the simplest to evaluate and make periodic interest payments. There is another type of corporate bond called floating rate notes (FRN). FRN's have a floating rate of interest which is made up of a benchmark rate called LIBOR plus a spread. The spread is determined by the maturity of the instrument and the credit rating of the corporation.

Municipal Bonds: They are bonds issued by the state, county and city governments of the US. The income earned from such bonds is tax free and provide the investors an incentive to invest in such instruments. The local government issues such bonds to finance projects. There are two types of municipal bonds:

General Obligation bonds which are backed by the government's ability to collect taxes and repay the bonds thereby providing security. Such bonds are backed by the full faith and credit of the local government.

Revenue bonds are those which are supported by the revenue collected by projects for which the funds were collected. These funds are used to repay the bonds.

Complex Debt Securities

The market for complex debt instruments has seen exponential growth. There are certain securities with complex features which make them difficult to evaluate. These include equity linked debt and dual currency bonds.

Equity Linked Debt: Companies who have lower credit ratings and wish to lower their cost of borrowing issue equity linked debt. They provide investors with incentive of participating in the company's earnings by linking the debt to equity. Companies use two methods to link bonds with equity:

Convertible Debt gives the bondholder the option to exchange the debt for a certain number of shares in the issuing company decided initially at the time of purchase. Sometimes debt holders have the option of converting debt into share of another company. The bonds can also be converted into other assets, commodities and fixed rate to floating rate debt.

Warrants are stand alone securities. It is a negotiable certificate and gives the owner the right to buy a certain number of shares at a predetermined price. The warrants can also be separated from the bonds and hence provide greater flexibility. Warrants issued by not attached to bonds are called "naked warrants". Without warrants the cost of borrowing increases and the interest paid is very high. Investors always have the option to sell the bonds and warrants separately. The warrant is usually exercised when the market price of the stock is greater than exercise price.

Dual Currency Debt: It is a hybrid security where debt is linked to various other assets/securities. Dual currency bonds make interest payments in one currency and principal payment in another. Such bonds as used by companies with operations in multiple nations and earnings in more than one currency. The bonds allow the issuers to take advantage of low interest rates level prevalent in countries with strong currencies which helps them lower their borrowing costs. Redemption rate is decided at issuance and bonds upon payments are semi-annual.

Advantages and Disadvantages

Advantages of Debt Financing:

Tax Deductions - In debt financing the principal and interest payments on a business loan are considered as expenses and can be deducted from the taxable income which further reduces the income taxes. The government is equivalent to a business partner with a certain percentage of stake in earnings depending on the tax rate. If the government stake can be reduced then it will be beneficial for the company.

Lower Interest Rate - You should also analyse the impact of tax deductions on the bank interest rates. If the bank charges you 10 percent on your loan and the tax rate is 30 percent there is a hidden advantage to take the loan. Take 10 percent and multiple it with (1-tax rate : 30%) and at the end you will only be paying 7 percent.

Maintain Ownership - When you take a loan from a bank or some other institution you are obligated to make the payments on time. But otherwise business can be run without any external interference.


Repayment - The only obligations of the borrower is repayment of principal and interest. So even in the case of failure of business the borrower is obligated to repay and if forced into bankruptcy then lenders have claim over share holders.

High Rates - Even after discounting interest rates by reducing tax deductions, the rates may still be high. Interest rates depend on a lot of factors like economic conditions, credit rating of the company etc.

Credit Rating - Debt financing is an attractive option to finance a company's needs but each time it resorts to debt it is leveraging up and increasing the debt to equity ratio. The higher you borrow the higher is the credit risk to the lender and hence the credit rating may decrease thereby forcing one to pay higher interest rates.

Cash and collateral - Even if the loan is invested in an asset it will have to generate enough cash flows to pay off the debt in the future. Also the issuer will have to place a collateral to pay the debt in case of defaults.

The Indian Debt Market

The debt market is more popular than equity markets in many parts of the world. However in India the reverse has been true. The major reason for this has been the dominance of the government securities in the debt market with the government borrowing at predefined coupon rates from a limited group of investors like banks. Thus there was a presence of a passive internal debt management policy. The policy combined with an automated monetisation of fiscal policy prevents a vibrant securities market.

The debt market in India comprises of two segments, government sector and corporate bonds. The market for government securities is the oldest and has the highest value of trading volume, number of participants etc. The government provides trading platforms like "negotiated dealing systems" and whole sale debt markets segment of the BSE and NSE. The PSU bonds are copies of sovereign paper, due to backing of the government and its ownership. The listen PSU bonds are traded in the whole sale market on the NSE.

Raising capital through public issuance is very small in the Indian debt market. A significant part is issued in the non government debt market on a private placement basis. Following is a table which provides data about institutions which raised capital through private and public placements. From the tables it is clear that private placements account for more than one third of the debt issuance. About 90% of the corporate sector debt has been raised through private placements. The amount raised has been rising continuously since the past five years with a growth rate of 300% over this period. The growth rate in public issues is only 80% for the same period.


Private Placement


Non - FI**













01-02 P**


12681.6 Table 1: Resource Mobilization in the Private Placement Market (Rs. crore)


Public Issue


Non - FI**













01-02 P**


19074.5 Table 2: Resource Mobilization through Public Issue

Table 3: Resources Mobilized by FI and Non- FI (per cent)



Non- FI





































*PP- Private Placement, ** PI - Public Issue

*Source-Handbook of Statistics on the Indian Economy, RBI ** P-Provisional, FI-Financial Institution,

Figure 1- The Structure of the Indian Debt Market


Issues of Concern

The following issues have been identified as major causes of concern affecting the Indian debt market:

Poor Quality Paper: Quality refers to the timely payment of interest and principal amounts at maturity. Companies making timely payments are said to be issuing high quality paper. It is the poor quality of papers that pose a threat to the development of capital markets and cause stringent laws to be implemented. In emerging economies the incidence of industrial sickness is very high. This sickness results into default of companies and their obligations. The bonds issued by companies are worthless and creates doubts in the minds of investors.

Inadequate liquidity: Secondary market for corporate debt lacks liquidity in India. Very few trades take place in a limited number of cases that too. Poor liquidity is attributable to insufficient number of good quality papers and lack of number of investors in terms of quantity. The liquidity issue can solved by:

Developing bond managers

Increasing number of investors

Introducing more number of good quality papers

Investor base: In many markets the number of investors investing in fixed income security runs into thousands with a wide variety of investors like mutual funds, pension funds, banks and retail investors. In India the only participants in the debt market are mutual funds investing in bonds and their participation being one sided with many mutual funds buying in large quantities if money starts coming in and selling in large quantities if money goes out. Insurance and pension funds are long term investors and so they can take on any small term risks involved. Now that there are more private and public sector players their presence in the primary as well as secondary market can be felt.

Regulatory Arbitrage: There are two types of companies which can operate in India: listed and unlisted. Both are governed by the Companies Act 1956, and regulatory administration by the ministry of finance. Listed companies are overseen by the SEBI and are hence required to follow corporate governance principles, accounting and disclosures standards and hence incur additional costs. Whereas unlisted companies enjoy regulatory arbitrage and hence this perception of companies to delist so that they can enjoy the arbitrage.

Debt vs Equity - Costs and Risks: Debt has a finite lifetime whereas equity lives perpetually. Hence debt is offered and reoffered frequently by companies. In falling interest rate economies companies borrow for the shortest possible period thereby increasing repeated issue costs, increasing interest rate risks and increasing the overall costs incurred. The corporate debt market suffers because of this.

Incomplete information access: Lack of timely and accurate information on bonds, bond markets, bond size, issue, coupons, credit ratings and trade statistics are major deterrent for investors to participate in the debt market. If investors have access to reliable information on a timely basis then it may be possible for them to assess the quality of paper and make investment decisions.

Interest Rate Structure: Interest rates provided by corporate bonds having "AAA" ratings provide rates lower than that offered by certain sovereign instruments like national savings certificate, , public provident fund etc. Individual investors therefore have no interest in coupon debt market unless provided with concessions leading to higher rates of return compared to the above instruments.

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