DEBT SECURITIES MARKET

Definition of Debt Securities and Debt Securities Market

 Debt securities refers to a document which creates or evidences a debt obligation.

 A money borrowed that must be repaid that has a fixed amount, a maturity date(s), and
usually a specific rate of interest. Some debt securities are discounted in the original
purchase price. Examples of debt securities are treasury bills, bonds and commercial paper.
 The debt or bond market is the environment in which the issuance and trading
of debt securities occur. Transactions are mostly made between brokers or large
institutions, or by individual investors.

General Characteristics of Debt Securities

a. They bear interest or are issued at a discount to their face value.

b. They are made by way of transferable instrument.

c. They must be redeemed by the issuer on a specified redemption date or in installments.

However, some debt securities are issued without a fixed redemption date such as
perpetual securities.

d. They can be listed on a stock exchange or issued to a pre-selected group of investors on

a private placement basis.

e. They can be either unsecured or secured on specific assets

f. They can be either full recourse, which means that holders of the securities have a claim
on the general assets of the issuer, or limited recourse, which means that the claims of
holders of the securities are limited to specified assets of the issuer.

Types of Debt Securities

Debt securities may be classified as money market debt securities and capital market debt securities.
Money market debt securities are those that have maturities of less than a year such as commercial
papers and certificate of deposits. Meanwhile, capital market securities include notes, bonds, and
mortgage-backed securities, which have maturity of more than one year.

Bonds, notes, and medium-term notes

 It is also known as a fixed-income security, is a debt instrument created for the purpose of
raising capital. They are essentially loan agreements between the bond issuer and an
investor, in which the bond issuer is obligated to pay a specified amount of money at
specified future dates.
 Bonds can be corporate bond, government bond, or municipal bond.
Commercial Paper

 A short-term security with a term of less than 365 days; an unsecured money market
instrument issued in the form of a promissory note.
 Commercial paper is usually issued at a discount from face value and reflects prevailing
market interest rates.

Interest-bearing securities

 Interest bearing means the loan carries interest at a pre-determined rate, and is repaid based
on an established time frame and interest rate.

Zero coupon securities

 This is also known as zero interest note or non-interest bearing note, this does not have
an interest rate and does not charge periodic interest payments on the outstanding liability.
In order for the lender to get a return on their zero interest notes payable, the notes are
issued at a lower price than their face value.

High Yield securities

 They are sometimes called as junk bonds, issued by non-investment grade issuers and are
sometimes subordinated to other specific debts of the issuer. They pay higher interest rates
than investment grade bonds to reflect their riskier nature. They are typically issued to help
finance or refinance a corporate acquisition and are typically subordinated to the other debts
of the issuer.

Bond Ratings

Bond rating agencies like Moody's and Standard & Poor's (S&P) provide a service to investors by
grading fixed income securities based on current research. The rating system indicates the
likelihood that the issuer will default either on interest or capital payments.

Investment grade refers to the quality of a company's credit. To be considered an investment grade
issue, the company must be rated at 'BBB' or higher by Standard and Poor's or Moody's. Anything
below this 'BBB' rating is considered non-investment grade. If the company or bond is rated 'BB'
or lower it is known as junk grade, in which case the probability that the company will repay its
issued debt is deemed to be speculative.

Investment grade Moody's Standard & Poor's Fitch

Strongest Aaa AAA AAA
Aa1 AA+ AA+
Aa2 AA AA
Aa3 AA- AA-
A1 A+ A+
A2 A A
A3 A- A-
 Baa1 BBB+ BBB+
Baa2 BBB BBB
Baa3 BBB- BBB-
Non-investment-grade Moody's Standard & Poor's Fitch
Ba1 BB+ BB+
Ba2 BB BB
Ba3 BB- BB-
B1 B+ B+
B2 B B
B3 B- B-
Caa1 CCC+ CCC+
Caa2 CCC CCC
Caa3 CCC- CCC-
Ca CC CC

Main Categories of Debt

Secured Debt

Secured debt is any debt backed by an asset for collateral purposes. Secured loans like this have a
fairly reasonable interest rate, which is based on the borrower’s creditworthiness and the value of
the collateral.

Unsecured Debt

Unsecured debt lacks any collateral. The lender is basing on the faith in the borrower’s ability and
promise to repay the loan. However, the parties are still bound by a contractual agreement to repay
the funds, so if case of nonpayment, the lender can sue to reclaim the money owed. Unsecured
debt generally comes with a higher interest rate. Some examples of unsecured debt include credit
cards, signature loans, gym membership contracts and medical bills.

Debt Seniority Ranking

If a corporation defaults on its obligations, it can be forced into bankruptcy liquidation, in which
case its assets will be sold off to repay the debts. Debts are repaid in a prescribed order of
priority. Senior debt comes first; junior or subordinated debt come after it.
 Figure 1. Debt Seniority Ranking

Senior Debt

Senior debt is a loan that a company must repay first if it gets into some financial trouble. It is the
most common form of lending and carries a low-interest rate, usually from a bank. Such debt is
more secure than any other type of debt as it usually is collateralized by assets. It means that such
lenders have a first lien claim on the company’s assets.

Advantages of Senior Debt

 It carries a lesser risk for the bank as it is secure and is paid off first in the case of bankruptcy.
 Senior lenders also enjoy an advantage in negotiations, like with junior lenders. Senior
lenders can dictate terms of the agreement, like how much should the borrower repay to the
junior lenders, and more.
 Since they carry a low-interest rate, it makes them attractive to the borrowers.

Disadvantages of Senior Debt

 If a company defaults on the payment, then it may lose the asset used as collateral for the
loan.
 Since it is a liability, it raises the expenses and financial burden for the company.
 Sometimes, senior lenders may put too many restrictions on the company’s capital
expenditure, dividends, and acquisitions.
Junior (Subordinated) Debt

A subordinated loan means first all the senior debts would be paid off in full from the assets and
earnings of the company. This type of loan is riskier than senior debts that is why every banks or
financial institutions that offer subordinated bond needs to be certain about the solvency and
affluence of the company before issuing subordinated bonds.

Reasons why subordinated bonds are often issued to large corporations:

 Large corporations have a big cash flow and non-current assets which will allow the banks
to get paid even for a subordinated loan.

 Large corporations have seen the low and high both and overcome the trials and turbulence
of business to be making huge revenue and serving a huge network of customers.

 Large corporations have better solvency than small business owners.

 The chances of going bankrupt for large corporations are much lower than small businesses
that have just been in business for few years. As a result, large corporations would be the
most appropriate borrower of subordinated debt.

Preferred Equity

In a liquidation, preferred stockholders have a greater claim to a company's assets and earnings
than common stockholders. The dividends for this type of stock are usually higher than those
issued for common stock. Preferred stock also gets priority over common stock, so if a company
misses a dividend payment, it must first pay any arrears to preferred shareholders before paying
out common shareholders.

Common Equity

Common stock represents shares of ownership in a corporation and the type of stock in which most
people invest. Common shares represent a claim on profits and confer voting rights.

Difference between Bonds, Preferred Stock, and Common Stock

Feature Preferred Common Bond

Ownership of Company Yes Yes No
Voting Rights No Yes No
Price of Security Is Based on: Earnings Earnings S&P Rating
Dividends Fixed Varies Fixed
Value if Held to Maturity Full Varies Full
Order Paid if Company Defaults Second Third First