Monday, October 8, 2012

Debt Securities

Many companies use debt to fund their operations and investments. Broadly speaking, there are two main types of debt finance: bank loans and debt securities. We have discussed bank loans – such as overdrafts, term loans and revolving facilities – extensively in past posts. This month we provide a brief overview of debt securities.

Debt securities are financial instruments that borrowers (who are referred to as “issuers” in this context) sell to investors.

Typically, a debt security entitles its holder to receive periodic interest payments from the issuer during the term of the security, as well as repayment of the security’s principal amount at the end of the term. For example, if you hold a 20-year, RO 1,000 bond paying a fixed 5% annual interest, the issuer is obligated to pay you interest of RO 50 per year throughout the 20-year term and then to pay you RO 1,000 at the end of the term. There are, of course, other variations that a debt security can take. Some debt securities carry the right to receive a fixed periodic interest rate, others a floating interest rate. Convertible debt securities give the holder the right to tender the security to the issuer in exchange for a given number of shares of the issuer’s common stock. Zero-coupon debt securities pay no periodic interest and only repay the principal amount.

Debt securities are thus used by companies to borrow money from investors as an alternative to borrowing from a bank. Many governments also issue debt securities. In Oman, both the Government and large corporations issue debt securities.

The name used to describe a debt security is often based on the length of its term. Longer-term debt securities are usually called “bonds”, whereas short-term debt securities may be called “commercial paper” when issued by companies or “bills” when issued by a government entity.

While bank loans continue to meet most Omani companies’ debt finance needs, debt securities are often a viable alternative or complement for large companies. It is also important to note that other forms of debt, such as vendor financing (e.g., when a corporate customer buys heavy equipment using a loan provided by the equipment manufacturer), play an important role for many Omani companies, particularly small and medium-sized enterprises.