What is debt (short answer)
– Debt is an obligation a borrower accepts to receive funds now and repay the lender later, usually with extra payment called interest. It can finance large purchases (house, car, education) or everyday spending (credit cards).
Key definitions (jargon defined on first use)
– Debt: A contractual obligation to repay borrowed money.
– Interest: The extra payment (usually a percentage) the borrower pays the lender for the use of funds.
– Loan: A debt where a fixed sum is advanced and repaid under an agreed schedule.
– Credit (open-end or revolving credit): A reusable borrowing limit (credit card or line of credit) without a fixed end date.
– Secured debt: A loan backed by collateral (an asset the lender can seize if you default).
– Unsecured debt: A loan with no collateral; approval is based on creditworthiness.
– Revolving debt: A credit arrangement that you can draw on repeatedly up to a limit and repay over time.
– Mortgage: A long-term secured loan used to buy real estate.
– Bond: A company’s debt security sold to investors; pays interest (coupon) and returns principal at maturity.
– Commercial paper: Short-term corporate debt with maturity up to 270 days.
How debt works (simple mechanics)
– For most loans: lender gives a principal (P). Borrower pays periodic amounts that include interest plus some principal until the loan is repaid by a maturity date.
– For revolving credit: the borrower may borrow, repay, and borrow again up to a set limit. Monthly payments often include interest on outstanding balances.
– Interest compensates lenders for the time value of money and credit risk. Secured loans typically have lower rates because collateral reduces lender risk; unsecured credit commonly carries higher rates.
Common consumer debt types
– Mortgages: long-term secured loans on homes (often 15 or 30 years). Can be fixed-rate or adjustable-rate (ARM), where the rate may change based on an index.
– Auto loans: secured by the vehicle.
– Student loans: typically fixed schedules; federal loans may offer several repayment plans (standard plan example below).
– Credit cards: revolving, unsecured credit used for routine purchases.
Corporate debt
– Loans from banks.
– Bonds: medium- to long-term instruments sold to investors with fixed or variable coupon payments and a maturity date.
– Commercial paper: short-term debt (≤270 days) used for working capital.
Differences — debt vs loan vs credit
– Loan: a specific form of debt with an agreed principal, schedule, and maturity.
– Credit: a broader concept describing the capacity to borrow; can be revolving (open-end) or closed-end (loan).
– All loans are debt
but not all debt is a loan. Debt is the broad category of obligations to pay money in the future; loans are one negotiated form of debt with a lender and a borrower. Other common debt instruments include bonds, commercial paper, and notes payable.
Classification and key terms
– Short-term vs long-term: Short-term (current) debt matures within 12 months; long-term debt matures after 12 months. On financial statements, short-term obligations are usually shown as current liabilities.
– Secured vs unsecured: Secured debt is backed by collateral (an asset the lender can seize); unsecured debt has no specific collateral and carries higher lender risk.
– Recourse vs nonrecourse: Recourse debt allows the lender to pursue the borrower’s other assets if collateral is insufficient; nonrecourse limits recovery to the pledged collateral.
– Amortizing vs bullet vs revolving: Amortizing loans repay principal gradually; bullet debt repays the principal in one lump sum at maturity; revolving credit (e.g., credit cards, lines of credit) allows borrowing, repaying, and re-borrowing up to a limit.
– Seniority and priority: In bankruptcy, debts rank by seniority. Senior secured debt is paid before subordinated/unsecured creditors.
Important ratios and formulas (with numeric examples)
– Net debt: total interest-bearing debt minus cash and cash equivalents.
Formula: Net debt = Total debt − Cash
Example: Total debt $500m, cash $100m → Net debt = $400m.
– Debt-to-equity ratio: measures leverage relative to shareholder capital.
Formula: Debt-to-equity = Total debt / Shareholders’ equity
Example: Total debt $500m, equity $400m → Debt-to-equity = 500/400 = 1.25.
– Interest coverage ratio (times interest earned): ability to meet interest payments from operating profit.
Formula: Interest coverage = EBIT / Interest expense
Example: EBIT $60m, interest $15m → Coverage = 60/15 = 4.0 (four times).
– Debt service coverage ratio (DSCR): ability to cover scheduled debt service (interest + principal).
Formula: DSCR = Operating income / Debt service (interest + principal due)
Example: Operating income $12m, annual interest + principal due $8m → DSCR = 12/8 = 1.5.
– Approximate yield to maturity (YTM) for a bond
– Approximate yield to maturity (YTM) for a bond: gives a quick estimate of the annualized return if the bond is held to maturity. Formula (approximate):
YTM ≈ (Annual coupon + (Face value − Price) / Years to maturity) / ((Face value + Price) / 2)
Example (step‑by‑step):
1) Face value (FV) = $1,000; annual coupon = $50; Price = $950; Years = 10.
2) Annual coupon = $50.
3) Capital gain per year = (1,000 − 950) / 10 = $5.
4) Numerator = 50 + 5 = $55.
5) Denominator = (1,000 + 950) / 2 = $975.
6) Approximate YTM = 55 / 975 = 0.05641 = 5.64% per year.
– Exact YTM: solves the bond price equation for the internal rate of return (IRR). Formula:
Price = Σ_{t=1..N} [C / (1 + y)^t] + FV / (1 + y)^N
where C = coupon, FV = face value, N = number of periods, y = YTM per period.
Practical note: this requires iteration (financial calculator, Excel’s RATE function, or an IRR solver). The approximate formula above is accurate enough for quick comparisons but can differ for long maturities or large discounts/premiums.
– Current yield: measures the coupon income relative to current market price (ignores capital gain/loss).
Current yield = Annual coupon / Price
Example: Annual coupon $50; Price $950 → Current yield = 50 / 950 = 5.263%.
– Clean price vs dirty price:
– Clean price: quoted market price excluding accrued interest.
– Dirty price (or invoice price): price actually paid = clean price + accrued interest since last coupon.
Example: If clean price = $950 and accrued interest = $12.50, dirty price = $962.50.
– Bond features and seniority (definitions and quick examples):
– Secured debt: backed by specific collateral (e.g
e.g., a mortgage loan on property or a lien on specific equipment). If the issuer defaults, secured holders have first claim on the pledged collateral. Recovery rates (percent of principal recovered in default) are typically higher for secured debt.
– Unsecured debt (debentures): debt not backed by specific collateral; holders rely on the issuer’s general creditworthiness. In a liquidation, unsecured holders rank below secured creditors but above equity.
– Senior vs subordinated (junior) debt: senior debt has priority for repayment over subordinated debt. Subordinated creditors are paid only after senior claims are satisfied. Subordination affects recovery prospects and required yield (subordinated debt normally offers higher nominal yields to compensate for greater risk).
Worked numeric example — priority in a liquidation
– Company liabilities (par amounts): Secured debt = $80m; Senior unsecured = $50m; Subordinated = $30m; Equity = residual.
– Asset realization in bankruptcy: suppose assets fetch $120m.
1. Secured creditors claim collateral first; assume collateral value covers all secured claims → secured recovered $80m.
2. Remaining assets for unsecured/subordinated = $120m − $80m = $40m.
3. Senior unsecured ($50m) are paid pro rata from the $40m → receive 80% recovery ($40m / $50m). Subordinated holders receive nothing.
– If assets were $180m, senior unsecured would be paid in full ($50m), subordinated would then receive $30m, and equity (if any left) would get the remainder.
– Callable bonds: issuer has the right to redeem the bond before maturity at a specified call price. Callability creates reinvestment risk for investors because bonds may be redeemed when rates fall. Example: $1,000 par bond, 5% coupon, callable at 102 after year 5. If rates drop, issuer may call and refinance; investor receives $1,020 instead of continuing at 5%.
– Putable bonds: investor has the right to require the issuer to repurchase the bond before maturity at a specified price. This feature reduces investor risk and usually lowers the yield compared with otherwise similar non-putable issues.
– Convertible bonds: bonds that can be exchanged for a predetermined number of shares of the issuer’s stock. Conversion ratio (shares per bond) and conversion price determine the equity value on conversion. Example: $1,000 par convertible bond with conversion ratio 20 → conversion price = $1,000 / 20 = $50 per share.
– Sinking fund provision: requires the issuer to retire a portion of the issue periodically, reducing outstanding principal over time. It lowers refinancing risk but can create supply pressure in the secondary market as the issuer buys back bonds.
– Covenants (contractual promises): clauses in the bond indenture that constrain issuer behavior.
– Affirmative covenant: actions the issuer must take (e.g., maintain insurance, file financials).
– Negative covenant: actions the issuer must avoid (e.g., limit additional secured debt, restrict dividend payments).
Stronger covenants generally reduce investor risk; weak or absent covenants increase it.
– Indenture and trustee: the indenture is the formal legal agreement between issuer and bondholders; a trustee (often a bank) enforces the indenture’s terms on behalf of bondholders.
Quick checklist for evaluating a debt instrument
1. Identify issuer type and credit rating (sovereign, corporate, municipal). Check recent ratings and outlooks.
2. Determine security and seniority (secured vs unsecured; senior vs subordinated).
3. Note explicit features: callable/putable, convertible, sinking fund, covenants.
4. Confirm exact cash flows: coupon type (fixed, floating), payment frequency, maturity.
5. Compute yield measures: current yield, yield to maturity (YTM), and if callable, yield to call (YTC). Be explicit about assumptions (e.g., reinvestment at YTM).
6. Assess liquidity and marketability (issue size, trading volume).
7. Consider tax treatment and jurisdictional legal protections.
8. Model downside scenarios: default probabilities and assumed recovery rates at each seniority level.
Simple formulas to compute common yields (assume annual coupons for simplicity)
– Current yield = Annual coupon payment / Price
– Approximate yield to maturity (for quick comparison) ≈ (Annual coupon + (Par − Price)/Years to maturity) / ((Par + Price)/2)
Note: YTM is best found by solving the present-value equation for yield; the approximation above is a shortcut and can be inaccurate for long maturities or large price deviations.
Practical step-by-step: how to compare two corporate bonds
1. Pull both bonds’ prospectuses (indentures) and recent financials for the issuers.
2. Confirm par, coupon, maturity, callable/putable features, and sinking funds.
3. Compute current yield and YTM for both using market prices.
4. If callable, compute YTC at the first call date and compare to YTM.
5. Check seniority and expected recovery rates in a default scenario; higher seniority reduces loss given
default. In other words, senior debt holders tend to recover a larger fraction of principal if the issuer fails; subordinated or junior creditors take bigger losses. Factor this into any yield comparison: a higher yield on subordinated debt compensates for lower expected recovery in default, not necessarily for a higher default probability alone.
6. Review covenants. Protective covenants are contractual limits on issuer actions (for example, restrictions on additional debt, dividend payments, asset sales). Stronger covenants reduce issuer optionality and protect bondholders; weak or absent covenants increase risk even if headline credit metrics look similar.
7. Check liquidity. Look at recent trade frequency, bid-ask spreads, and dealer inventories. Illiquid bonds often trade at extra yield (liquidity premium) that can be hard to capture if you need to sell quickly.
8. Consider taxes and regulatory treatment. Some bonds (municipal, foreign, or certain structured products) have special tax treatments. Corporate bond yields should be compared on an after-tax basis for taxable investors. Banks and insurers may face regulatory capital charges that affect demand for some debt types.
9. Measure interest-rate sensitivity (duration). Duration quantifies how much a bond’s price changes for a given change in yield. Higher duration = greater sensitivity to interest-rate moves. Use modified duration for small yield changes; for larger shifts or for callable bonds, compute effective duration (which accounts for the possibility of early redemption).
10. Use market-implied measures. Credit spreads (bond YTM minus comparable Treasury yield) and credit-default-swap (CDS) spreads provide market views of default risk. Changes in these measures often precede rating actions.
11. Run scenario and stress tests. Simulate outcomes under:
– base-case (current yield curve, no call)
– best-case (issuer refinances when rates fall, likely call)
– worst-case (issuer default; assume recovery %s by seniority)
Compute portfolio impact in each scenario.
12. Make a decision checklist before trading:
– Did I confirm legal seniority and collateral?
– Did I price both YTM and worst-case yield-to-call?
– Did I run recovery-weighted expected loss if default occurs?
– Is the bond liquid enough for my horizon?
– Does the bond fit my risk allocation and tax situation?
Worked numeric example (step-by-step)
Compare two 10-year corporate bonds with $1,000 par, annual coupons.
Inputs:
– Bond A: coupon 6.0% ($60/year), price = $950, noncallable, maturity = 10 years.
– Bond B: coupon 7.0% ($70/year), price = $1,020, callable at par ($1,000) in 5 years, maturity = 10 years.
– Reference 10-year Treasury yield = 4.50%.
Step 1 — Current yield:
– Current yield = Annual coupon / Price.
– A = 60 / 950 = 0.06316 = 6.316%.
– B = 70 / 1,020 = 0.06863 = 6.863%.
Step 2 — Approximate yield to maturity (YTM shortcut):
– Approx YTM ≈ (Annual coupon + (Par − Price)/Years) / ((Par + Price)/2).
– A: (60 + (1,000 − 950)/10) / ((1,000 + 950)/2) = (60 + 5) / 975 = 65 / 975 = 6.667%.
– B (ignoring call): (70 + (1,000 − 1,020)/10) / 1,010 = (70 − 2) / 1,010 = 68 / 1,010 = 6
3267% (≈6.7327%).
Step 3 — Approximate yield to call (for B only)
– Use the same shortcut but set Years = years until earliest call and Par = call price.
– B is callable at par ($1,000) in 5 years.
– Approx YTC ≈ (Annual coupon + (Call price − Price)/Years_to_call) / ((Call price + Price)/2).
– B: (70 + (1,000 − 1,020)/5) / ((1,000 + 1,020)/2) = (70 − 4) / 1,010 = 66 / 1,010 = 0.0653465 = 6.5347%.
Step 4 — Compare yields and spreads (numeric)
– Reference 10‑year Treasury = 4.50%.
– Bond A (noncallable):
– Approx YTM ≈ 6.667% → spread ≈ 6.667% − 4.50% = 2.167 percentage points (216.7 basis points).
– Bond B (callable):
– Approx YTM ≈ 6.733% → spread ≈ 6.733% − 4.50% = 2.233 percentage points (223.3 bps).
– Approx YTC ≈ 6.535% → spread ≈ 6.535% − 4.50% = 2.035 percentage points (203.5 bps).
Interpretation (what this means for an investor)
– Two possible outcomes for B:
1. If the issuer does not call B, the investor (holding to maturity) realizes something close to the YTM ≈ 6.733%.
2. If the issuer calls B at the first call date (5 years), the investor realizes the YTC ≈ 6.535% (and must reinvest principal at prevailing market rates then).
– Because YTC < YTM for B, the call feature reduces the bond’s upside for the investor when rates fall (call risk). In other words, the issuer keeps the option to refinance if doing so is beneficial to them; that option is a cost to the investor.
– Bond A, being noncallable (or assumed not callable in this example), does not carry that specific call risk; its approximate YTM of 6.667% is the relevant single yield metric if held to maturity.
Practical checklist to evaluate callable vs noncallable bonds
1. Calculate current yield, approximate YTM, and (if callable) approximate YTC.
2. Compute spread to an appropriate risk‑free benchmark (e.g., Treasury) for YTM and YTC.
3. Ask: which outcome is more likely given interest‑rate expectations?
– If you expect rates to fall, callable bond will more likely be called → use YTC.
– If you expect rates to rise or stay, bond likely won’t be called → use YTM.
4. Consider reinvestment risk: early call forces reinvestment, likely at lower rates.
5. Check call schedule, call premium (if any), and other covenants in the prospectus.
6. Adjust for taxes, liquidity, and credit risk as needed.
Worked decision example (qualitative)
– If a conservative investor expects interest rates to remain around current levels or rise, they can reasonably plan on receiving something close to YTM for either bond; A’s 6.667% is nearly the same as B’s 6.733%.
– If the investor expects rates to fall materially over the next 5 years, Bond B is more likely to be called and the investor should focus on B’s YTC (≈6.535%), reducing the effective compensation versus a noncallable alternative.
Assumptions and limitations
– The shortcut formula is an approximation; exact YTM/YTC requires solving the present‑value equation for the internal rate of return.
– These calculations assume annual coupon payments and call at par; actual bond docs may specify different timing, frequency, or call premiums.
– Market conditions, taxes, transaction costs, and credit events (defaults, ratings changes) are not modeled here.
Further reading
– Investopedia — Debt: https://www.investopedia.com/terms/d/debt.asp
– U.S. Department of the Treasury — Interest Rate Statistics: https://home.treasury.gov/policy-issues/financing-the-government/interest-rate-statistics
– Securities and Exchange Commission (SEC) — Bonds and Bond Investing: https://www.sec.gov/reportspubs/investor-publications/investorpubsbondshtm.html
Educational disclaimer
This explanation is educational only and not individualized investment advice. It does not recommend buying or selling any security. Consult a licensed financial professional for personal guidance.