Debt is the obligation that an individual contracts when he asks for something, with the commitment of returning it according to previously agreed conditions.
The definition of the term is defined as the obligation to return the capital in the agreed term and with the fixed interest rate. The amount owed is the sum of the requested capital plus the interest that corresponds.
When a bank, entity, State … issues debt for investment or financing reasons, in the contractual relationship that is contracted, it corresponds to the debtor (they issue debt and incur the obligation to repay the principal plus interest), and who buys they are the ones who disburse the principal and receive interest in exchange.
Types of debt depending on the issuer
Depending on who issues that debt we can find:
- Public debt: these are all the debts that the State has with investors (national or international).
- Private debt: is the debt that has any person, physical or legal that is not a public administration.
Debt companies, we find that the States are the ones that are financed the cheapest (since there is a lower risk of non-payment of that debt, that is, they have a greater solvency to return their commitments), in second place, we find the interbank market where financial institutions lend money to a higher rate than the states can finance, and finally, we find companies, that is, companies that under normal market conditions must pay the rate of higher interest The longer the term and the risk, the higher the interest rate required. The graph is a graphical representation between term and profitability called temporary structure of interest rates.
Types of debt based on credit quality
The same company can issue different types of debt according to the instrument issued, said instrument will have a specific rating and this will directly affect the risk assumed by an investor when buying said debt. This rating, among other things, is the same as that of the other instrument (debt) issued by that economic agent at the time of default.
The risk is determined based on the moment in which the investor recovers his money in case the company breaks. If at any time the issuer of said financial asset could not meet its commitments or the event of default occurs, then the return of the commitments contracted based on an order (order of priority) will begin. The most risky (the last in the table) will be the last to collect, while those who are first in the table, will be the first to charge. That is why the interest rate will be received during the life of the asset will be higher.
We can find different categories of debt:
- Secured Senior Debt: the well-known mortgage bonds, are those backed by the mortgage loan portfolio of the issuer (they can only be issued by banks).
- Senior Debt: they are bonds or obligations in all their modalities. They can differ in the form of payment of coupon, the term, periodicity or indexation to some economic variable such as inflation.
- Subordinated Debt: subordinated debt is a debt of lower quality than the previous ones. Where the collection of interest may be conditioned to the existence of certain level of benefits. In this case, the investor does not receive anything because the issuer does not favorably evolve (if it does not reach a profit level). An example is the Preferred Participations.
- Hybrid Debt: in case of bankruptcy or liquidation of the issuer, the holders of hybrids are only above the shareholders in terms of priority of collection. They are usually instruments issued at very long term or perpetual, the issuer having the ability to cancel on certain dates (a call option is incorporated, that is, a right to amortization).
- Actions: here we no longer buy debt but shares, that is, it is an investment in capital. And capital investors are always the last to charge, since they are the partners of the company.
The securitization is a financial process by which an illiquid financial asset generates a series of predictable and stable over time financial flows into another liquid changes. Through securitization the debt comes off balance sheet.
In this way, in the process of titling, a special company is created (off the balance sheet of the bank) where securitized bonds are issued that will pay investors at certain interest rate. In the event that a loan has been securitized, the cash flow coming from said loan will be what the investor receives.
They have been widely used for their ability to convert illiquid assets into liquids and for their risk distribution mechanism since it improves the capital ratio of banks by transferring off-balance-sheet risk.
- Mortgage bonds: is the process by which the bond is backed by a loan portfolio, which in turn can be residential or commercial mortgage loans. They are also called in English Mortgage backed Securities.
- Non-mortgage qualifications : How can you get loans to cars, from student loans, from invoices, etc., that is, backed by any asset that is not a mortgage loan.