What Is Debt
Debt refers to an obligation in the form of cash or other assets that the creditor transfers to the borrower (debtor) subject to their repayment in the future and/or payment of interest. It allows individuals or legal entities to perform operations for which they otherwise would not have had sufficient financial resources.
By increasing debt obligations, the company can form its borrowed capital, which goes to finance production activities. The success of the company largely depends on the competent management of obligations. If a company comes to a state where it cannot pay its debts, then it is called bankrupt.
Debt is a commitment by which one party (the debtor) undertakes to perform (refrain from performing) a certain action. This may be a transfer of a particular product, a transfer of a certain amount of cash, and so on.
Debt may arise on the basis of a contract (for example, payment for the goods delivered) or law (for example, tax debt).
In addition to the debt definition, Monfex offers detailed definitions of about 100 financial terms. Check them out at Monfex.com.
Types of Debtors
In general, there are the following types of debtors:
- Individuals and households. It is the simplest form of debt that includes mortgages, car loans, credit card debt, and income tax. In addition to these formal debts, individuals also provide informal loans to other people, mostly relatives or friends.
- Non-financial companies. Companies can use debt to finance their operations if they do not have enough capital, or simply as financial management tools. These debts are also called corporate.
- Financial companies (central banks and other financial institutions). Central banks create and manage special types of obligations for the purposes established by their statutory documents and industry legislation. Financial institutions are companies that buy and sell debt, such as banks, trust companies, brokerage, insurance and leasing companies, institutional investors, and hedge funds.
- Government. This is the debt of the state, sub-federal entities, and local government. It is based on several concepts of debt, such as public (the debt of all public legal entities), government (part of public debt minus the municipal debt), national (government debt on issued or government loans), and sovereign (debt that arose as a result of a bond issue and is protected by sovereign immunity).
A debt instrument is an obligation documented in electronic or paper form, which reflects the financial relationship between the borrower (issuer) and the lender investing the funds.
A DI indicates the obligation of the borrower to repay the debt according to the regulations established in the contract. DIs are bonds (both municipal and corporate), securities, bills, and deposit certificates.
An important advantage of a DI is that it allows you to manage obligations in the most efficient way: by trading. During such financial interaction, investments are protected, it is still possible to receive interest payments as well as repay the main debt. But at the same time, lenders can use the funds of investors.
These are the most popular types of DIs:
- Deposit certificate. It is considered a low-risk investment, allowing you to receive average income from invested funds. While these funds are circulating in the banking system, they are involved, for the most part, in maintaining high liquidity. They can also be used in any other areas of banking.
- Bonds. These instruments allow you to earn income with a high degree of reliability and low risk. Bonds are typically issued in such a way that the interest and the cost must be paid in time. Bonds can participate in various types of financial relationships. For example, an investor can sell them to maintain liquidity or receive interest payments in a specified period, having the guarantee for reimbursement of the nominal value.
- Securities. These are the documents that are used to provide legal security for short-term loans. They contain all basic information: type of loan, terms of repayment, amount, etc. Like bonds and certificates, they can be bought and sold, while the obligations of the borrower are not transformed in any way.
Characteristics of Debt Instruments
Each DI has a set of characteristics that determine its reliability and liquidity. These characteristics are inherent in each obligation and differ only in values.
The key parameters of a DI are as follows:
- Maturity. This term refers to a certain period of time, after which the issuer is obliged to fully repay both the principal amount and interest. After this period, the issuer is completely released from obligations in the case of timely and full payment. There are situations when the issuer or investor can change the maturity. This characteristic allows you to classify bonds by market. So, a liability with a maturity of up to 1 year inclusively relates to the money market, and more than 1 year - to the capital market.
- Nominal cost. This term refers to a certain amount that the borrower agrees to repay before the maturity. The nominal value differs depending on the type of a DI. The liability price is deducted as a percentage of the principal. That is, if the repayment price of the instrument is $1,000 and it is sold for $900, then its price is $90.
- Coupon rate. It is also called the nominal or contract rate. This rate determines the size of the issuer's annual payments. To calculate the monetary equivalent of a rate, you need to multiply its size in percent by the redemption value. The resulting amount will be an annual payment. The frequency of payments depends on the type of instrument. Interest on commercial papers and assets is typically deducted on a monthly basis.
- Zero coupon. It is a characteristic of a DI indicating that the interest has not been paid for a certain period of time. This distinguishes the zero coupon from the contract rate, which determines the systematic payment. The investor’s income is composed not of the interest rate, but of the difference between the nominal value and the one at which the DI was purchased.
Now you know what is debt, what are the types of debtors, and which debt instruments exist on the market. For more financial definitions, refer to glossary at Monfex.com.