A debt instrument is a fixed-income asset that legally obligates the debtor to provide the lender interest and principal payments.
Accessing debt financing requires the debtor to pay the creditor according to pre-defined contractual terms. The contract should outline the interest payment schedule, collateral if applicable, interest rate, maturity date, covenants, and if the debt is convertible.
Debt instruments are fixed-income assets that legally obligate the debtor to provide the lender interest and principal payments.
When a company wants to raise capital, they can opt to raise capital by using internally generated funds, equity financing, and debt financing.
Debt financing can be a great source of risk for businesses, primarily through increased liquidity and solvency risk.
Bonds are the most common debt instrument. Bonds are created through a contract known as a bond indenture. They are fixed-income securities that are contractually obligated to provide a series of interest payments of a fixed amount and also repayment of the principal amount at maturity.
Bonds appreciate in value when market interest rates decrease. It follows the logic that the present value of a bond’s future cash flows is less when a greater discount rate is applied.
How Do Credit Ratings Affect Debt Instrument Valuations?
Generally, investors prefer bonds with a lower default probability; therefore, riskier bonds must compensate investors for greater default probability. Credit ratings allow investors to rank debtors in order of default probability.
Countries, corporations, and individuals all have credit ratings that have a direct causal relationship with the entity’s ability to access debt financing. An increase in a bond’s rating will increase the price of the instrument and therefore increase its yield.
Who Issues Bonds?
Corporate bonds can be issued by financial companies or non-financial companies to investors.
The primary governmental entities that regularly issue bonds include:
1. Sovereign National Governments
Debt instruments issued by a national government – examples include US Treasury Bonds, Canadian Treasury Bonds, etc.
2. Non-Sovereign Governments
Government entities that are not national governments can access debt financing through bonds – examples include state government bonds, municipal bonds, etc.
3. Quasi-Government Entities
Debt instruments issued by organizations that do not represent a country’s governmental organization or bonds
4. Supranational Entities
Global organizations like the World Bank and International Monetary Fund (IMF)
Advantages of Debt Instruments
If a company properly invests borrowed funds through debt instruments, it can increase profitability. The process of financing through creditors to maximize shareholder wealth is referred to as leverage.
If the investment returns are greater than the interest payments, the debtor will be able to generate profits on the debt financing. In the field of private equity, companies make investments through leveraged buyouts that are built around the investment to provide greater returns than the interest payments.
Disadvantages of Debt Instruments
Debt financing can be a great source of risk for businesses, primarily through increased liquidity and solvency risk. Liquidity is hindered because interest payments are classified as a current liability and represent a cash outflow within one year.
Liquidity and solvency are important factors to consider, especially when assessing a company based on the going-concern principle. Debt financing is popular among individuals, companies, and governments.