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Debt Origination (in Capital Markets)

The process of raising debt within the capital markets

What is Debt Origination (in Capital Markets)?

Debt origination is the process that companies, financial institutions, and government entities go through in order to raise debt.

Companies may use debt proceeds to finance operations, internal projects, and acquisitions. Financial institutions may use debt to alter their exposures and match the durations of their assets with 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 from various sources.

 

Summary

  • Debt origination is the process of raising debt within the capital markets.
  • Origination includes bridging the gap between the needs of debt issuers and investors, in addition to assessing the interest rate environment.
  • Origination is primarily carried out by investment banks, which act as intermediaries in the debt-raising process.

 

Understanding Debt Origination

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 lenders through marketing materials
  2. Origination – Finding suitable lenders to fill the debt raising needs of the borrower
  3. Syndication – The group of investment banks and investors needed to fill a debt offering are assembled
  4. Structuring – Creating financial instruments that are investable to lenders and meet the needs of borrowers, in addition to setting the price of the issuances
  5. Execution – Finalizing process and ensuring the debt capital is secured and available to the borrower

In the capital markets, debt origination is largely carried out by investment banks. The process includes bridging the requirements of a party that needs debt capital (an issuer or borrower) with the parties that are willing to lend debt capital (investors) at a specified price or interest rate.

 

Debt Origination

 

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

  • Other companies
  • Financial institutions (banks, insurance companies)
  • Government entities

 

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 lenders’ side, originators must evaluate 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, spending, or 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).

 

Practical 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 $100 million to do so and are looking to raise debt to finance the investment.

Debt originators will assist in meeting the funding needs of the manufacturer by raising debt from various sources. However, the originator must be sensitive to the market and 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 could be many more investors and a syndicate of investment banks that work together to originate the debt securities. Furthermore, there could 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).

 

More Resources

Thank you for reading CFI’s guide to Debt Origination (in Capital Markets). To keep advancing your career, the additional CFI resources below will be useful:

  • Asset-Backed Securities (ABS)
  • Credit Spread
  • Financial Intermediary
  • Investment Banking vs Commercial Banking
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