Types of long term debt

Entry Notes

Posted: 08192010
Author: Jean Bonnette
Category: Debt and credit

The following types of long-term debt are covered here:

  • 1. Term loans
  • 2. Bonds
  • 3. Debentures
  • 4. Mortgage bonds
  • 5. Convertible bonds
  • 6. Senior debt
  • 7. Subordinated debt
  • 8. Junk bonds

Term Loans. This is the form of long-term debt most frequently used by businesses. It is a loan from a bank to acompany that is used to finance expansion efforts. It has afixed maturity date, frequently five to seven years from the date ofthe loan. The company will repay the loan in monthly installments ofprincipal and interest. Spreading the payments of the principalover the life of the loan is called loan amortization. The monthly payments of principal and interest are called debt service. The amortization of the principal can take place over a period that islonger than the loan period. With this arrangement, theremaining principal is due at the end of the loan period. That endingbalance is called a balloon payment.

Bonds. A bond has many characteristics similar to those of a term loan. The differences are:

  • 1. A bond is a negotiable instrument that can bebought and sold like common stock.
  • 2. A bond is usually sold to the public through apublic offering registered with the Securities and ExchangeCommission.

Bonds are usually sold in units of $1,000. A bond thatis selling at its face value is said to be selling at par. The interest rate is called the coupon. After these securities are issued, their prices fluctuate in accordance with economic conditions. The prices ofmany of these securities are quoted daily in all majorfinancial publications. Bonds are usually interest payments only withprincipal repaid at maturity.

Debentures. A debenture is a bond with only ‘‘the full faith and credit’’ of the company as collateral. Other thanthe credit rating and creditworthiness of the debtor, there is nospecific collateral. The owners of these bonds, therefore, are classifiedas unsecured creditors.

Mortgage Bonds. A mortgage bond differs from a debenture only in that there is specific collateral to back upthe security. Owners of these bonds are known as secured lenders.Because of this collateral, the interest rate should be lowerthan that on a debenture.

Convertible Bonds. This is a type of debenture with a very interesting feature. If a company does not have a highcredit rating and therefore does not qualify for a reasonableinterest rate, it would be prohibitively expensive for that company tosell bonds. Remember that investors and lenders have verydifferent risk/ reward relationships. An investor may take a very highrisk in the hope of experiencing a very high reward. A lender cannever make more that the interest rate, and thus a lenderthat takes a very high risk may lose everything without having theprospect of a high reward. The convertible bond changes therisk/reward relationship for the lender.

The bond is sold at a relatively low interest rate,perhaps 7 percent rather than the 12 percent that the companywould otherwise have to pay. The owner of the bond has theright to convert the bond into shares of common stock at alater date.

The company enjoys an affordable interest rate and cannow expand its business. The owners of the convertible bonds getsome interest and share in the rewards of success if thecompany does well and the price of the stock increases to above apredeter190 mined threshold price called the strike price. Prices of convertible bonds are listed in the bond price tables in majorfinancial publications with the extra symbol CV.

Senior Debt. This is a debenture issue that gives its holders priority over the holders of all other debentureissues in receiving interest payments and access to the company’s assetsin case of a bankruptcy.

Subordinated Debt. Holders of this type of debt have priority below that of the holders of senior debt. Because ofthis secondary position and the resulting higher risk position,holders of this debt will receive a higher interest rate than theholders of senior debt.

Junk Bonds. The creditworthiness of most companies and their securities is rated by various agencies such asStandard & Poor’s and Moody’s. Generally bonds with the three orfour highest ratings are classified as investment grade. Bonds inthis category are recommended for pension funds and veryconservative investors.

Bonds that do not qualify for these high ratings havea much smaller pool of available buyers. As a result, theymust pay considerably higher interest rates, and so they are classified as ‘‘high yield.’’ As a company’s creditworthiness declines, theyield on its bonds increases at an increasing rate because of the incrementally greater risk. When bonds reach a very-high-yield,lowerquality status, they are known as ‘‘junk’’ bonds.

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