Debt Origination (Capital Markets)

What is Debt Origination in the Context of Capital Markets?

Debt origination is the process that larger borrowers, such as corporations, financial institutions, and government entities, go through in order to raise debt. Generally speaking, the amount and frequency that the borrowers are looking to raise exceed the threshold for a traditional financial institution or group of financial institutions to undertake.

Companies may use debt proceeds to finance operations, internal projects, and acquisitions. Financial institutions may use debt to alter their exposures and match the duration of their assets with that of their liabilities. Governments may raise debt to finance projects or support the economy.

Debt is raised through the debt capital markets, utilizing investment banks as an intermediary to assist in raising capital. The investment banks act as a middleman to help distribute the debt raising to institutional investors, such as pension funds, hedge fund managers, and private banks.

Debt Origination Explained

As mentioned, debt origination is the process that companies undertake in order to raise debt. In the context of capital markets, it is only one part of the process of raising debt.

The total process of raising debt includes:

1. Marketing – Generating interest and gauging potential demand from prospective investors through marketing materials
2. Origination – Finding enough suitable investors at the borrower’s desired borrowing rate to fulfill their debt-raising needs
3. Syndication – The group of investment banks and investors needed to fill a debt offering are assembled
4. Structuring – If required, using lucrative derivatives, such as interest rate swaps, to tailor-make the cashflows of the bond raising to meet the specific needs of both the borrower and investor
5. Execution – Finalizing process and working with external lawyers to ensure the debt capital is properly documented, registered with the required regulators, and funds received and disbursed.

The Role of the Debt Capital Markets (DCM)

The debt capital markets (DCM) are a function of the capital markets that are associated with debt securities. Investment banks employ DCM teams that are responsible for the origination, structuring, execution, and syndication of various debt-related products.

Debt-related products include interest-bearing instruments such as:

• Bonds
  • Investment-grade bonds
  • High-yield bonds
  • Government bonds
  • Emerging markets bonds
  • Municipal bonds
• Bills
• Notes
• Commercial paper
• Asset-backed securities
• Hybrid securities (such as convertible debt)

The securities may be issued by companies looking to raise capital to finance investments or finance an acquisition or other growth opportunities. The borrowers will raise from various types of investors, including those mentioned above and:

• Asset managers
• Financial institutions (banks, insurance companies)
• Central banks and sovereign wealth funds

Importance of Investment Banks in the Debt Origination Process

Investment banks are important intermediaries that carry out the debt origination process within the capital markets. Included in the process are three key factors:

1. Assessing the lenders’ needs
2. Assessing the borrowers’ needs
3. Assessing the interest rate environment in order to make a deal work for both parties

On the investors’ side, originators must gauge several factors, including:

• Overall investor appetite
• Whether investors looking to get fixed income exposure to certain companies/industries
• The types of exposure they are looking for
• The time to maturity they are looking for
• The risk tolerance and investment mandate of the investor
• The investor’s benchmark
• Lastly, whether the investor is asset-driven or liability-driven

On the other side of the deal, the borrower’s or issuer’s needs must be considered, including:

• Whether the issuer is a corporation, a financial institution, or a government entity
• The uses of the debt are important as well, for example, whether the entity is using the debt for the capital structure, for spending, or for lending out at a higher rate
• The amount that the borrower needs
• The borrower’s ability to weather insufficient demand from investors

The interest rate environment is very important to consider in the pricing of debt deals since the market interest rate serves as a benchmark for debt instruments. Pricing is generally done through the use of credit spreads relative to a reference government benchmark (such as the U.S. Treasury yield), which is considered a risk-free asset. Floating rate bonds are priced as a spread to a different reference benchmark (such as LIBOR or SOFR).

In return for their efforts, the investment bank charges an underwriting fee to help intermediate the debt raising. The fee depends on several factors, such as:

• The complexity of the transaction
• The creditworthiness of the borrower
• The relationship with the borrower
• How innovative the investment bank can be in helping address the needs of the borrower
• How competitive other investment banks are in offering lower fees to the borrower for the same debt-raising

Furthermore, the investment bank may also make money from helping either the borrower or the investors structure the cash flows from the debt raising to suit their needs, called “hedges.” It is usually done with financial instruments called “derivatives,” which can either help reduce costs for the borrower or enhance the return for investors. Because of the opaque nature of pricing derivatives, the hedges are very lucrative for investment banks, often more so than the fees.

Debt Origination Example

As an example, let’s say there is an industrial parts manufacturer that needs to raise debt to finance the refurbishing of one of their large manufacturing facilities. They require $300 million to do so and are looking to raise debt to finance the investment.

Given the large amount of the debt to be raised, the company’s primary bank is unable to provide the financing by itself and believes that even a small group of bank lenders (called a “club deal”) would not be able to take down the entire loan.

The company’s banker refers the manufacturer to their investment banking division colleagues, who can assist in meeting the funding needs of the manufacturer by raising debt from institutional investors from the public markets. However, the originator must be sensitive to the market and must structure the deal in a way that ensures it can be sold to investors.

The above is a highly simplified example. For larger debt issuances, there tend to be many more investors and a syndicate of investment banks that work together to originate the debt securities. Furthermore, there can be multiple types of securities issued, with some investors being higher on the capital structure (greater claim to assets in the event of a default).

Additional Resources

Asset-Backed Securities (ABS)

Credit Spread

Financial Intermediary

See all fixed income resources