What is a debt issue?
– A debt issue is a contractual borrowing arrangement in which an entity (the issuer) raises money by selling a debt instrument to investors (the lenders). The issuer promises to pay periodic interest and to return the principal (face or par value) on a specified future date (maturity). Common examples include bonds, debentures, notes, certificates, mortgages, and lease obligations.
Core terms (definitions)
– Coupon: the periodic interest payment on a debt instrument, usually expressed as a percentage of face value.
– Face value (par value): the principal amount repaid at maturity (e.g., $1,000 for many corporate bonds).
– Maturity: the time until the issuer must repay principal; categorized as short-term (1–5 years), medium-term (5–10 years), or long-term (over 10 years).
– Yield to maturity (YTM): the internal rate of return an investor would earn if they buy the bond today and hold it to maturity, assuming payments are made as promised.
– Underwriting: the service (often provided by investment banks) that purchases a new debt issue from the issuer and resells it to investors; underwriters typically charge fees.
– Credit rating: an assessment from agencies (e.g., Moody’s, S&P, Fitch) of an issuer’s likelihood to meet debt obligations; affects the interest rate investors demand.
Why entities issue debt instead of taking a bank loan
– Flexibility: market-issued debt often imposes fewer restrictions on how proceeds may be used than some bank loans.
– Access to a broader investor base: capital markets can provide larger and more diverse funding sources.
– Potentially lower cost: government debt is typically cheaper than corporate debt because of lower default risk; corporations with strong credit ratings may also secure favorable rates.
How debt issuance typically works — two tracks
1) Corporate issuance (common path)
– Board approval: the company’s board usually authorizes the plan to borrow.
– Underwriting: one or more investment banks buy the entire issuance, form a syndicate to market and resell the bonds, and charge fees.
– Pricing: coupon and sale price reflect company creditworthiness, investor demand, and prevailing market interest rates.
– Use of proceeds: the issuer receives cash to fund projects, expansion, or refinance existing liabilities.
2) Government issuance (auction-based)
– Governments often sell debt in public auctions rather than via underwriters.
– In some countries (e.g., the U.S.), retail investors can buy directly through official platforms (for U.S. Treasuries: TreasuryDirect).
– Government debt generally carries lower yields because it is backed by the government’s taxing power or full faith and credit.
Costs and fees associated with issuing debt
– Explicit costs: coupon interest payments and principal repayment.
– Issuance costs: underwriting fees, legal fees, registration fees, auditing and regulatory costs. These reduce net proceeds and raise the effective borrowing cost.
– Credit-related cost: the higher the perceived default risk, the higher the yield investors will demand (often expressed as a spread over a risk-free benchmark such as U.S. Treasuries).
How the cost of debt is measured
– Market YTM: the current yield-to-maturity of a traded debt instrument is a direct market measure of borrowing cost.
– Rating-based approach: use issuer credit rating to determine a spread over the risk-free rate; add that spread to the risk-free rate to estimate cost.
– After-tax cost: interest expense is usually tax-deductible for corporations, so the effective cost equals the pre-tax borrowing rate times (1 − corporate tax rate). This after-tax cost is used in calculations like the weighted-average cost of capital (WACC).
Practical checklist — for issuers (quick)
– Confirm board authorization and corporate approvals.
– Decide target amount, maturity, and coupon structure (fixed vs. floating, payment frequency).
– Choose sales method: underwriting syndicate or auction.
– Obtain or review credit rating (if applicable).
– Budget for issuance costs (underwriting, legal, registration, auditing).
– Prepare prospectus/offer document and complete regulatory filings.
– Execute sale; plan for interest payments and principal repayment schedule.
Practical checklist — for bond investors (quick)
– Check issuer type: corporate, municipal, or government.
– Review maturity and coupon schedule.
– Examine credit rating and recent financials.
– Compare yield (YTM) to benchmark (Treasuries) and peers.
– Factor in tax treatment (e.g., municipal interest may be tax-exempt).
– Consider liquidity and secondary market trading costs.
Worked numeric example: how coupon, fees, and taxes affect the issuer’s effective cost
Assume:
– A company issues a single bond with $1,000 face value, annual coupon rate = 6% (so $60 per year), maturity = 10 years.
– Underwriter fees and issuance costs total 2% of face value = $20.
– Corporate tax rate = 21%.
Step 1 — annual cash interest = 6% × $1,000 = $60.
Step 2 — net proceeds to issuer = $1,000 − $20 = $980 (issuer actually receives $980 today).
Step 3 — simple pre-tax effective interest rate (approximate) = annual interest / net proceeds = 60 / 980 = 0.06122 → 6.122%.
Step 4 — after-tax effective cost = pre-tax rate × (1 − tax rate) = 6.122% × (1 − 0.21) = 4.84% (approx).
Interpretation: issuance fees raised the company’s effective pre-tax borrowing cost from 6.00% to about 6.12%; after accounting for the tax shield, the net cost to the firm
is about 4.84% annually after tax.
Interpretation and key caveats
– What that number means: issuance fees increased the issuer’s effective pre-tax borrowing cost from the 6.00% coupon rate to roughly