Debt refers to capital that is borrowed by one party from another party. It is a contractual agreement between a borrower and a lender. The borrower pays back the loan before a specified date, usually with a specified (annual) interest rate.
Loans and bonds are the most common types of debt which always have a fixed cost of capital. Debt is usually used to finance larger investments that the borrower cannot pay for with its own capital. The borrower expects that by investing the provided capital of a loan, it can capitalise on opportunities that allow future repayments and interest of the loan to the lender (while still making a profit).
What is debt in general?
Debt is a deferred payment that becomes due in the future. It usually consists of the original amount to be repaid and a recurring interest payment. Both are specified in a contractual agreement.
The provider of debt (often the bank) requires certainties that it will receive its funds back.
These certainties can consist of a solid (financial) track record, company or personal liability and guarantees. Examples of company or personal liabilities are collateral on assets, such as real estate or intellectual property, and convertible debt. Several types of financial institutions provide debt capital, among others: commercial banks, (multilateral) development banks, provincial / municipal development companies or funds, national promotional banks and institutions (NPBIs) and private debt funds that are funded by institutional investors such as pension funds and insurance companies.
Although debt is usually provided on a long-term (>1 year), short-term debt (<1 year) is sometimes offered as well. An example of a short-term type of debt is a working capital facility that provides coverage to solve a project’s low to negative liquidity. In case of a bankruptcy the borrowing legal entity is liable for the sum of the loan.
Issuing bonds provides a suitable alternative to attract capital when a bank loan is insufficient to fund the required amount.
Bonds allow the issuer to raise capital from a larger universe of lenders and to spread the debt over different individuals or lenders.
Bondholders are compensated for lending the money by receiving fixed or variable interest payments (called the coupon). Bonds typically have a long maturity (5-30 years). Bonds are seen as a relatively low risk investment as they are prioritised for repayment over stocks. Similar to stocks, bonds can be publicly traded, via a broker or privately between borrower and lender. Their price is dependent on the maturity date, the principal and the coupon rate, the market conditions and the trustworthiness of the issuer.
Especially green bonds can be an interesting instrument for circular economy initiatives.