OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a

OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a

promise to repay it at some future time. The obligation to repay is

FINANCING DECISIONS

referred to as debt or indebtedness; the borrower is the debtor; and the lender is the creditor. The creditor is also an investor, because he is lend- ing money at one point in time and expecting it back in the future, along with compensation for lending his money. We refer to indebtedness between a borrower and a lender as a loan. If the borrower issues a security to represent the indebtedness, we usually refer to the borrower as the issuer and the lenders as noteholders or bondholders, depending on the type of security representing the indebtedness.

The amount borrowed is called the principal and is repaid either at the end of the period of indebtedness or at regular intervals during this period. When the entire principal is repaid only at the end of the period of the indebtedness, the debt obligation is said to have a bullet struc- ture. If, instead, the principal payments are made over time based on a schedule, the debt obligation is said to have an amortizing structure.

The lender receives interest to compensate for lending funds. For some types of debt the interest is paid periodically, and for other types is paid at the end of the debt period. The interest rate can be a fixed rate or a variable rate. When the interest rate is a variable rate, more popu- larly referred to as a floating rate, there is a formula that sets forth how the interest rate on the debt obligation will be determined at the interest reset date. The formula is called the interest rate reset formula. The gen- eral formula for the floating rate is:

Floating rate = Reference rate + Quoted margin

The reference rate is the interest rate on some contractually specified market interest rate or some other benchmark. The quoted margin is fixed over the life of the debt obligation. The amount of the quoted mar- gin depends on the credit quality of the borrower and other features of the debt obligation. The lower the credit quality of the borrower, the higher the quoted margin. The date on which the rate on the debt obli- gation is changed is called the reset date. The period over which the new rate applies is called the reset period.

For example, suppose that a debt obligation’s reset period is one year and the reference rate is the 1-year London interbank offered rate (LIBOR). Suppose further that the quoted margin is 200 basis points. That is, the formula for its floating rate is

1-year LIBOR + 200 basis points

So, if 1-year LIBOR at a reset date is 3%, then the floating rate for the reset period would be 5%. If at a subsequent reset date 1-year LIBOR increases to 4.2%, then the floating rate for that reset period would be 6.2%.

Intermediate and Long-Term Debt

A floating-rate debt obligation can have a maximum interest rate imposed. This means that if the interest rate reset formula at a reset date indicates that the interest rate is greater than the maximum interest rate specified, the formula is overridden. The maximum interest rate in a floating-rate debt obligation is referred to as a cap. For example, sup- pose that the cap is 7% and that the formula is the one used earlier, 1- year LIBOR plus 200 basis points. Then if 1-year LIBOR is 6% at the reset date, in the absence of the cap the formula would set the rate at 8%. However, this is above the cap of 7%. The rate for the period is then set at the cap, 7%. A cap is an advantage to the borrower and a disadvantage to the lender.

There are some floating-rate debt obligations that set a minimum interest rate. The minimum interest rate is called a floor. The floor is an advantage to the lender and a disadvantage to the borrower.

The lender cannot be absolutely sure that the borrower will repay the principal and pay the interest when promised. Realizing that, bor- rowers typically specify this assurance in the form of a promise to repay with property they own, if necessary. Failing to pay when promised, the creditors force the sale of this property to be repaid from the proceeds.

We refer to debt backed by property as a secured debt and to the property as security or collateral. If there is no security, the creditor relies entirely on the ability of the borrower to make the promised pay- ments. We refer to this type of debt as unsecured.