Types of debt


Debt is the obligation that an individual contracts when he asks for something, with the commitment to return it according to previously agreed conditions.

Being more precise in the definition, the debt is the obligation to return the capital within the agreed term and with the fixed interest rate. The amount owed is the sum of the capital requested plus the corresponding interest.

When a bank, entity, State ... issues debt either for investment or financing reasons, in the contractual relationship that is contracted, it corresponds to the debtor (they issue debt and contract the obligation to return the principal plus interest), and that who buys said debt becomes its creditor (they are those who disburse a principal and receive interest in return).

Types of debt depending on the issuer

Depending on who issues that debt we can find:

  • Public debt: These are all the debts that a State maintains with investors (national or international).
  • Private debt: It is the debt that any person, physical or legal, that is not a public Administration has.

Under normal conditions, we find that the States are the ones that are financed the cheapest (since there is latent a lower risk of non-payment of that debt, that is, they have a greater solvency to repay their commitments), secondly, we find the interbank market where financial entities lend money at a rate higher than that which states can finance, and finally, we find companies (corporates in English), that is, companies that under normal market conditions must pay a rate of best interest. The longer the term and the risk, the higher the required interest rate. The graph is a graphical representation between term and profitability called the term structure of interest rates.

Types of debt based on credit quality

The same company can issue different types of debt depending on the instrument that is issued, said instrument will have a specific rating and this will have a direct impact on the risk that an investor assumes when buying said debt. This rating, among other things, determines the position that this instrument occupies in relation to the rest of the instruments (debt) issued by that economic agent when a default occurs.

The risk is determined based on when the investor recovers his money in the event of the company going bankrupt. If at any time the issuer of said financial asset could not meet its commitments or the event of default, will then begin the return of the commitments contracted based on an order (order of priority). The most risky (the last in the table) will be the last to collect, while those that are the first in the table, will be the first to collect. That is why the interest rate to be received during the life of the asset will be higher the more risk is assumed.

We can find different categories of debt:

  • Senior secured debt: The well-known covered bonds are those backed by the issuer's portfolio of mortgage loans (they can only be issued by banks).
  • Senior debt: They are bonds or obligations in all their forms. They may differ in the form of coupon payment, the term, periodicity or indexation to some economic variable such as inflation.
  • Subordinated debt: Subordinated obligations are debt of poorer quality than the previous ones. Where the collection of interest may be conditioned to the existence of a certain level of benefits. In such a case, the investor does not receive anything at maturity if the issuer does not evolve favorably (if it does not reach a profit level). An example is Preferred Securities.
  • Hybrid debt: In the event of bankruptcy or liquidation of the issuer, holders of hybrids are only above shareholders in terms of collection priority. They are usually very long-term or perpetual instruments issued, with the issuer having the ability to cancel on specified dates (a call option is incorporated, that is, a right to redeem).
  • Shares: here we no longer buy debt but shares, that is, it is an investment in capital. And equity investors are always the last to collect, since they are the partners of the company.

Debt securities

Securitization is a financial process by which an illiquid financial asset that generates a series of predictable and stable financial flows over time is transformed into another liquid. Through securitization the debt goes off the balance sheet.

Thus, in the titling process, a special company is created (off the bank's balance sheet) where securitized bonds are issued that will pay investors a certain interest rate. In the event that a loan has been securitized, the flow of flows from said loan will be what the investor receives.

They have been widely used for their ability to convert illiquid assets into liquid assets and for their risk distribution mechanism as it improves the capital ratio of banks by transferring risk off-balance sheet.

  • Mortgage titles: It is the process by which the bond is backed by a portfolio of loans, which in turn can be residential or commercial mortgage loans. They are also called in English Mortgage backed Securities.
  • Non-mortgage securities (Asset Backed Securities): Such as ABS of car loans, ABS of student loans, ABS of invoices, etc., that is, ABS backed by any asset that is not a mortgage loan.
External debt Payment agreement

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